Tax and Mortgage Documents Are Worth Keeping Forever
By Benny L. Kass
(c) The Washington Post
Saturday, January 27, 1996; Page F05
Do we really have to keep all our records forever? It's a paper jungle out there, and most of like to
throw away unimportant papers on a periodic basis.
Unfortunately, there are many legal
requirements as to what kind of documents have to be kept by the taxpayer, and -- more
importantly -- how long these records should be maintained.
The easiest solution to record keeping, of course, is to keep all of your records forever. However,
this is not only impractical, but also unnecessary.
The law is specific: As long as the taxpayer's return is open for audit by the Internal Revenue
Service, the taxpayer is required to keep his or her books and records.
In the law, there are statutes of limitations. For example, if you are injured in an automobile
accident, depending on what the statutory period is in the jurisdiction where you live, after that
period has elapsed, you are not permitted to file suit against the driver who hit you.
The theory behind these statutes is that the courts -- and the legislatures -- want to put an end to a
cause of action. Often, depending on state law, the statutory period will be three to five years,
relating to a particular type of action.
In our automobile accident, for example, if the statute of limitations is three years, the theory is that
this should be sufficient time for you to determine your damages, and then file suit. As a practical
matter, these statutes are designed to cut off your rights, so that you will be unable to file suit five
or 10 years later.
There is a three-year statute of limitations for the IRS to assess a tax against you. Once this
three-year period has expired, and the Internal Revenue Service is no longer permitted to examine
your returns for a particular year, you do not have to keep your documents.
This is an oversimplification, however. The IRS is permitted to go beyond those three years if, for
example, income has been substantially under-reported by the taxpayer.
Additionally, there is no
statute of limitations if a taxpayer files a false or a fraudulent return. The return for that year can be
audited -- and a tax assessed -- at any time.
If the taxpayer does not report all of his or her income, and that amount is more than 25 percent of
the income shown on the tax return, there is a six-year statute of limitations from the time the return
is filed.
However, most records must be kept by the taxpayer for only three years after the tax return is
filed. For example, records relating to information on a timely filed 1995 tax return (Form 1040)
should be kept until at least April 15, 1999.
Keep in mind, however, that if you obtained an extension of the April 15 deadline, the three years
are calculated from the date of the extended due date. If you filed your return but did not pay your
tax until a later date, the statute does not run until two years from the date the tax is paid.
That is the general law on the keeping of books and records. But, there are many documents --
particularly in the real estate arena -- that must be kept longer.
If you bought real estate, whether as your principal residence or as an investment, you should keep
all of your records for at least three years from the date you sell that property. Indeed, if, for
example, you sold your property in December 1995, you should keep your records for at least
three years from the date you filed your 1995 income tax return that reflected that sale.
More importantly, and as will be discussed later in this series, because taxpayers are using such
legal techniques as rollovers and once-in-a-lifetime exemptions, it is important to determine the
basis (purchase price) when the property is ultimately sold. This means you have to go back to the
day your very first property was purchased.
Also, because the tax on the profit (gain) of real estate is now quite high -- 28 percent for federal
purposes -- it is important that you keep careful and accurate records of all improvements made to
your property.
It should be noted that even if Congress does reduce the capital gains tax this year, even that lower
tax will be calculated based on profit; thus, you still will need to keep all your documents to justify
your tax return.
Keep in mind that for every dollar you can document as a home improvement, you will save 28
cents that does not have to go to the federal government.
Example: If you purchased your house for $75,000, and improved it with a major addition worth
$60,000, your basis in the property is $135,000. When you sell the property later for $200,000
and do not take advantage of any of the tax savings devices, your profit is only $65,000
($200,000 minus $135,000).
However, the burden of proof falls directly on you, the taxpayer. It is not acceptable merely to
When it comes to tax records, the easiest solution is to keep all of your documents forever. This is
not always practical, however. tell the IRS auditor that you believe you put $60,000 worth of
improvements in the house some time in early 1980. You will be required to provide proof of the
cost of these improvements. If you do not have this proof, there is a strong likelihood that the IRS
agent may reject your claim of improvements.
Under the tax code, if a taxpayer does not have books and records (or they are inadequate) the
IRS has the authority to reconstruct the situation. However, the tax code gives the IRS full
discretion to determine the method of computing the situation; clearly, this may result in an
unsatisfactory solution for you.
Additionally, if you intend to take advantage of the once-in-a-lifetime $125,000 exemption, it
should be understood that you are taking this exemption away from the profit that you have
already made. Thus, it is important to document what deductible costs you have incurred above
and beyond the purchase price.
Many homeowners in the Washington area have found their profit is well above the $125,000
limitation. Thus, every dollar that can be added to basis creates a savings for you and puts that
additional money in your pocket for retirement purposes.
Items such as recording and transfer taxes, settlement costs, title insurance and legal fees, are all
legitimate items to be added so that basis can be raised and thus your profit will be lowered.
But the burden is on the taxpayer to demonstrate the authenticity -- and accuracy -- of these costs.
I strongly recommend that anyone who buys a home keep all of the settlement sheets as a
permanent record. When the last house is sold, and the applicable statute of limitations has
expired, then -- and only then -- can you destroy those vital documents.
It is also important to document any unallocated mortgage points that you were unable to deduct
over the years. Points paid to obtain a refinanced mortgage generally will not be deductible in the
year they are paid. You have to allocate them over the life of the loan.
For example, if you paid $2,500 in points, for a 30-year loan, you are entitled to deduct only
$83.33 each year. However, if you sell the house or refinance the loan before the 30 years, the
remaining unallocated and nondeducted points can be deducted in full in the year you sell and pay
off that loan.
Although you do not have to keep your tax returns beyond the period of the statute of limitations, I
strongly recommend that these be kept forever. They do not take up a lot of room in storage, and
you may periodically want to refer to them for reasons that go beyond an IRS audit. Often, a
mortgage lender or other potential creditor may want to review your tax returns for the past few
years.
If you do not have a copy of your tax return, you can obtain it by sending the IRS a form 4506,
titled "Request for Copy of Tax Form." You can obtain the form by calling 1-800-829-3676.
Thus, even in the age of the computer, paper documents must be kept as long as the IRS has the
legal authority to audit your tax returns.
Benny L. Kass is a Washington lawyer. For a free copy of
the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped
envelope to Benny L. Kass, Suite 1100, 1050 17th St. NW, Washington, D.C. 20036.
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