Know Which Tax Records To Keep?

It’s that time of year that businesses and individuals start to clean and want to toss old unnecessary documents. There are a few items to consider as you start your spring cleanup. Records may have to be produced if the IRS (or a state or local taxing authority) was to audit your return or seek to assess a tax. In addition, lenders or other parties may require that you produce copies of your tax returns as a condition to lending money, approving a purchase, or in doing other business with you.

Keep returns indefinitely and the supporting records for six years. Generally, except in cases of fraud or substantial understatements of income, the IRS can only assess tax within three years of that year’s filing. (For the state of California, this is four years). For example, if your 2012 individual income tax return is filed by April 15, 2013, the IRS will have until April 15, 2016 to assess a tax deficiency against you. If you file your return late, the IRS generally will have three years from the date you filed to assess a deficiency.

However, the three-year rule isn’t ironclad. The assessment period is extended to six years if more than 25% of gross income is omitted from a return. In addition, the IRS can assess tax at any time (even beyond three or six years) if no return was filed for a tax year. Keeping a copy of the return will help to refute this claim.

While it’s impossible to be sure that the IRS won’t assess tax at some point, retaining tax returns indefinitely and important records for six years after filing should, as a practical matter, be adequate. The backup to the returns, including all bank statements, general ledgers, checks and supporting documents, can generally be destroyed after six years.

Records relating to property may have to be kept longer. The tax consequences of a transaction that occurs this year, such as a sale of property, may depend on events that happened years ago. The period for which you should retain records must be measured from the year in which the tax consequences actually occur.

When new property takes the basis of old property, such as in a like-kind section 1031 exchange or trade-in, 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 bought a car for business use in 1999 and you traded it in on a new car for business use in 2002. If you sell that car in 2013, your basis in the car will determine whether you have a tax gain or loss on the sale, and your basis in the car is determined, at least in part, by your basis in the car you traded in for it in 2002. Accordingly, records relating to your old car should be kept until 2020 (six years after your 2013 return is filed in 2014).

Similar considerations apply to other property that is likely to be bought and sold—for example, 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 buy additional shares of stock, each reinvestment is a separate stock purchase. The records of each reinvestment 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 the casualty and theft loss deduction is determined in part by your basis in the damaged or stolen property, you’ll need to have records to support that basis, until six years after you file the return claiming the loss deduction.

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 business or 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 business or home in an emergency.

Scan and backup. Consider scanning all records over two years old and retaining them electronically at an offsite location or in a cloud based solution.  This saves on space and protects the records from loss or destruction.  Make sure that the scanned documents are complete and make multiple electronic backups of the scanned documents to ensure they are accessible when needed.