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Think Twice Before Tossing: The Critical Timing for Disposing of Your Tax Records Safely

Article Highlights:

  • Why We Keep Records
    o   Audit Defense
    o   Amending Returns
    o   Claiming Refunds
    o   Tax Basis

  • Duration for Keeping Tax Records
    o   Federal Statute of Limitations on Tax Refunds
    o   Tax Return Omissions
    o   Indefinite Retention
    o   Financially Disabled

  • The Big Problem!
    o   Stock Acquisition Data
    o   Stock and Mutual Fund Statements
    o   Tangible Property Purchase and Improvement Records

  • The 10-Year Statute of Limitations on Collections

Now that your taxes are complete and filed for last year, you are probably wondering what old tax records can be discarded. If you are like most taxpayers, you have records from years ago that you are afraid to throw away. To determine how to proceed, it is helpful to understand why the records needed to be kept in the first place. Generally, we keep “tax” records for several reasons: 

Audit Defense: In the event of an IRS audit, taxpayers are required to present documentation supporting the claims made on their tax returns. Without proper records, defending against audit adjustments becomes significantly challenging.

Amending Returns: If taxpayers need to amend a return due to discovered errors or overlooked deductions, having detailed records makes the process smoother and ensures that all adjustments are accurate.

Claiming Refunds: For claiming refunds, especially those related to overpaid taxes, detailed records are necessary to substantiate the claim.

Tax Basis: When capital assets, such as stock, business assets, rentals and other investments are disposed of it is necessary to determine for tax purposes if there was a gain or loss from the transaction. The tax basis is what the asset cost plus or minus adjustments such as the cost of improvements which increase the tax basis, depreciation (reduces basis), casualty losses, or tax credits which decrease the tax basis. 

Duration for Keeping Tax Records - The general rule of thumb is to keep tax records until the statute of limitations for the tax return in question expires. The statute of limitations is the period during which the taxpayer can amend their tax return to claim a credit or refund, or the IRS can assess additional tax. 

Federal Statute of Limitations on Tax Refunds: The statute of limitations on tax refunds is a set of rules defined by the Internal Revenue Code that determines the time frame within which a taxpayer can claim a credit or refund for overpaid taxes. This statute serves two main purposes:

  • It specifies how long an individual has to file a claim for a refund or an amended return after the original return was filed or the tax was paid.

  • It sets limits on the amount of refund or credit that can be claimed, based on certain conditions.

    Some states have longer statutes, typically 4 years, so they have more time to piggyback on any federal audits and adjustments.

    Example: Sue filed her 2023 tax return before the due date of April 15, 2024. She will be able to safely dispose of most of her records after April 15, 2027. On the other hand, Don files his 2023 return on June 2, 2024. He needs to keep his records at least until June 2, 2027. In both cases, the taxpayers should keep their records a year or two longer if their states have a statute of limitations longer than three years. Note: If a due date falls on a Saturday, Sunday or holiday, the due date becomes the next business day.

Tax Return Omissions: In certain situations, such as when a taxpayer does not report income that they should report, and it is more than 25% of the gross income shown on the return, the IRS suggests keeping records for six years.

Of course, the statute doesn’t begin running until a return has been filed. There is no limit on the assessment period where a taxpayer files a false or fraudulent return to evade tax.

Indefinite Retention: For records related to property, the IRS recommends keeping them for as long as the property is owned and for at least three years after filing the return reporting the sale or other disposition of the property. This is crucial for calculating depreciation, amortization, or gains or losses on the property.

Financially Disabled - Additionally, the time periods for claiming a refund are suspended for taxpayers who are "financially disabled". A taxpayer is financially disabled if they are unable to manage their financial affairs because of a medically determinable physical or mental impairment that can be expected to result in death or that has lasted or can be expected to last for a continuous period of not less than 12 months. For a joint income tax return, only one spouse need be financially disabled for the time to be suspended. However, a taxpayer is not treated as financially disabled during any period their spouse, or any other person, is authorized to act on their behalf in financial matters. 

The Big Problem! The problem with discarding records indiscriminately for a particular year once the statute of limitations has expired is that many taxpayers combine their normal tax records and the records needed to substantiate the basis of capital assets such as stocks, bonds, and real estate. These documents need to be separated, and the basis records should not be discarded before the statute expires for the year in which the asset is disposed. Thus, it makes more sense to keep those records separated by asset. The following are examples of records that fall into this category: 

Stock Acquisition Data — If you own stock in a corporation, keep the purchase records for at least four years after the year the stock is sold. This data will be needed to prove the amount of profit (or loss) you had on the sale. And if the result of those sales, and sales of other capital assets, is a loss that you’ll be carrying forward to future tax returns – loss exceeds $3,000 ($1,500 if filing as married separate) – keep the purchase and sale records for four years after filing the return on which the last of the loss is used up.

Stock and Mutual Fund Statements — Many taxpayers use the dividends that they receive from a stock or mutual fund to buy more shares of the same stock or fund. The reinvested amounts add to the basis in the property and reduce gains when the stock is finally sold. Keep statements for at least four years after the final sale.

Tangible Property Purchase and Improvement Records — Keep records of home, investment, rental property or business property acquisitions, AND related capital improvements for at least four years after the underlying property is sold.

In addition, if you own a business that has a loss that creates a net operating loss (NOL) that you’ll be carrying forward to deduct in future years, you should keep all the business’s records that substantiate income and expenses from the loss year for at least four years after filing the return on which the NOL deduction is used up. 

The 10-Year Statute of Limitations on Collections – Although this has nothing to do with the theme of his article, “how long does the IRS have to collect unpaid tax?” is an often-asked question. The tax code puts a 10-year limit on the time period the IRS can pursue the collection of a tax debt. This statute of limitations begins from the date the tax was assessed and not from the tax year for which the debt was incurred. Understanding this limitation is crucial for taxpayers for several reasons: 

Collection Activities: The IRS has various collection activities at its disposal, including tax liens, levies, and wage garnishments. However, these activities are bound by the 10-year statute of limitations.

Installment Agreements: When a taxpayer owes federal tax and can’t immediately pay it, they may enter into an installment payment agreement with the IRS. In this case the clock on the 10-year statute does not stop. This means the IRS must collect the full amount owed within the original 10-year period unless specific conditions extend this period.

Have questions about whether to retain certain records? Give this office a call before tossing out those documents. It is better to be sure before discarding something that might be needed down the road.

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