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Retention of Tax Records

How long should you retain your personal income tax records? These records may have to be produced if the Internal Revenue Service (or a state or local taxing authority) were to audit your return or seek to assess or collect a tax. In addition, lenders, co-op boards, or other private parties may require that you produce copies of your tax returns as a condition to lending money, approving a purchase, or otherwise doing business with you.

Keep returns indefinitely and the supporting records usually for six years

In general, except in cases of fraud or substantial understatements of income, the IRS can only assess tax for a year within three years after the return for that year was filed (or, if later, three years after the return was due). For example, if you filed your 20X1 individual income tax return by its original due date of April 15, 20X2, the IRS would have until April 15, 20X5 to assess a tax deficiency against you. If you filed your return late, the IRS generally would have three years from the date you filed the return to assess a deficiency.

The problem with the three-year rule is that the assessment period is extended to six years if more than 25% of gross income is omitted from a return. In addition, the assessment period doesn’t begin to run until a return is filed. Therefore, if the IRS claims that you never filed a return for a particular year, it can assess tax for that year at any time (even beyond three or six years), unless you can prove you did file. Proving that you filed would, of course, be impossible after you have discarded your returns.

While it is impossible to be completely sure that the IRS will not at some point seek to assess tax, retaining tax returns indefinitely and important records for six years after the return is filed should, as a practical matter, be adequate.

Records relating to property may have to be kept longer

Keep in mind that the tax consequences of a transaction that occurs in one year may depend on things that happened in earlier years, and that the period for which you should retain records must be measured in the year in which the tax consequences actually occur. This may be significant, for example, where you sell property that you bought years earlier.

For example, suppose you bought your home in 2015 for $200,000 and made an additional $20,000 of capital improvements in 2018. To determine the tax consequences of the sale, it is necessary to know your basis (i.e., original cost plus later capital improvements). For example, if you sell your home in 2022, and your return for that year is audited, you may have to produce records relating to the purchase in 2015 and the capital improvement in 2018 to be able to show what your basis is. Therefore, those records should be kept for at least six years after your 2022 return has been filed, instead of just six years after the transaction they relate to occurred. Even though as much as $250,000 of home sale gain can now escape tax (up to $500,000 for joint return filers), you should still retain all records relating to home purchases and improvements. There is no telling how much the home will be worth when it is sold, and there is no guarantee that the home sale exclusion will still be available when the future sale takes place.

When new property takes the place of old property, records relating to the old property should be kept until six years after the sale of the new property is reported. For example, suppose you purchased a car for business use in 2014 and you traded it in on a new car for business use in 2016. If you sell the new car in 2018 your basis in the new car is determined, at least in part, by your basis in the car you traded in 2016. Accordingly, records relating to your old car should be kept until 2022 (i.e. six years after your 2016 return is filed).

Similar considerations apply to other property that is likely to be purchased and sold. An example would be stock in a business corporation or in a mutual fund, bonds (or other debt securities), etc. In particular, remember that if you reinvest dividends to purchase additional shares of stock, each reinvestment is a separate purchase of stock, and the records of each investment should be kept for at least six years after the return is filed for the year in which the stock is sold.

Because the calculation of a casualty and theft loss deduction is determined in part by your basis in the damaged or stolen property, you will need to have records to support that basis, until six years after you file the return claiming the loss deduction.

Separation or divorce

If separation or divorce becomes a possibility, be sure you have access to any tax records affecting you that are kept by your spouse. Or better still, make copies of the tax records, since in such situations, relations may become strained and access to such records difficult.

Your records should include a copy of the divorce decree or agreement of separate maintenance, which may be needed to substantiate alimony payments and distinguish them from child support or a property settlement. Copies of all joint returns filed and supporting records are important, since liability for tax on a joint return is joint and several and a deficiency may be asserted against either spouse. Your records should also include agreements or decrees over custody of children and any agreements as to who is entitled to claim an exemption for them. Retain records of the cost of all jointly owned property. Also, get records as to the cost or other basis of all property your spouse transferred to your marriage, or as a result of the divorce, because your basis in that property is the same as your former spouse’s basis.

Loss or destruction of records

To safeguard your records against loss from theft, fire or other disaster, you should consider keeping your most important records in a safe deposit box or other safe place outside your home. In addition, consider keeping copies of the most important records in a single, easily accessible location so that you can grab them if you have to leave your home in an emergency.

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