RSM Resources

When it comes to personal recordkeeping, especially for taxpurposes, many people err on the side of caution, accumulating piles offiles they safely could destroy. However, even some conscientiousindividuals fail to keep a few very important documents that could savethem significant dollars. Are you keeping the right records for theright amount of time?

The mere mention of the IRS may stir upfears of audits, penalties and legal hassles. But honest taxpayers havelittle reason to worry if they arm themselves with some basicinformation. When it comes to recordkeeping for tax purposes, the IRShas established comprehensive, straightforward guidelines that everytaxpayer should follow.

What and how long: A recordkeeping primer
Inshort, keep records that you used to prepare tax returns and whichsupport the claims you made on your returns. That includes records toidentify sources of income, verify expenses, and establish the value ofyour home, other real estate, and investments such as stocks and bonds.

Documents taxpayers should archive generally fall into four areas:
Income.Bank and brokerage statements, and forms W-2 (wage and tax statement),K-1 (beneficiary’s share of income, deductions and credits, forexample) and 1099 (other income). If you have any atypical income suchas tips, check with the IRS or a tax consultant for additionalrecordkeeping requirements.
Expenses. Salesinvoices, receipts and cancelled checks or other proof of payment. Forcash transactions, be sure receipts clearly indicate what you purchasedand the date. Private transactions should be signed.
Home.Closing statements, purchase and sales invoices, proof of payment,insurance records and, if you sold a home prior to 1998, IRS Form 2119(sale of your home).
Investment assets. Brokerage and mutual-fund statements, forms 1099 and 2439 (undistributed long-term capital gains).

Howlong should you keep these records? The basic IRS review period isthree years. During that time, the IRS can audit your tax return foralmost any reason, including a taxpayer’s death. Under the followingcircumstances, the IRS can extend the period for reviewing returns.

• Ifyou file a claim for a tax credit or refund after you file your return,the IRS can extend the basic review period to the later of three yearsor two years after you paid the tax.
• If the IRS suspects you underreported your income by 25 percent or more, the review period is six years.
• If you file a claim for a loss from worthless securities, the review period is seven years.
• If you file a fraudulent return or fail to file a return, the review period is unlimited.

Mosttax professionals — assuming they’re working with honest, law-abidingcitizens — advise taxpayers to keep basic records for at least sevenyears. However, you must keep one category of records — those thatdocument the basis of assets — indefinitely or make a mistake that oneday could cost you thousands of dollars.

Avoiding the "basis" downfall
Oneof the most common and costliest mistakes honest taxpayers make isdisposing of records necessary to establish the basis of their home orinvestment assets such as real estate, stocks or bonds. The IRS usesthe basis, or initial cost or value of the asset to the owner, and thevalue of an asset at the time the owner sells it to calculate thecapital gain, which may be taxable. If you can’t establish the basis,the IRS may tax the entire sales price as a capital gain. Consider, forexample, you paid $500,000 for land and sold it for $1.5 million. Ifyou were unable to establish the basis, you would pay capital-gainstaxes on $1.5 million instead of $1 million.

Sometimes it’spossible to retrieve missing records. For example, if you lost orfailed to keep records regarding stock transactions, your broker may beable to produce copies (although, if your broker goes out of businessor merges with another firm, it may be more difficult to track down therecords you need). If you inherited stock and didn’t properly establishthe basis at the time, it may be impossible to do so years later. Thebest approach with any investment asset, including your home, is togather the records you need to clearly document the basis at the timeyou acquire the asset. Keep those records for at least three yearsafter you dispose of the asset. If you’re not sure how to establish andmaintain the basis, consult a tax professional.

A simple approach to tax recordkeeping
Onceyou know what to keep and for how long, develop a recordkeeping system.Organizational experts recommend a simple approach: Set up a basicfiling system for storing the necessary documents each year beforepreparing your tax return. A three-ring binder with dividers and tabs,a small hanging file with manila folders, or part of a drawer in afiling cabinet should work.

Don’t overcomplicate matters, oryou’re not as likely to follow through. If you decide to use hangingfiles, for example, label one folder for each of the four basiccategories of documents: income, expenses, home and investment assets.Put the documents where they belong as soon as you get them. Afterpreparing your return, place it and all supporting documents in asingle, large envelope, and label it by tax year. If you dispose of oldreturns after the seven-year waiting period, remember to remove andkeep any documents you will need to establish the basis for your homeor any other investments you still own.

Finally, you may have toguard against keeping too much stuff. For example, unless you use yourhome as a place of business, you don’t need to keep copies of electricor other utility bills. Or, if your medical expenses weren’t enough toitemize on your return, you can safely toss out your doctor bills orpharmacy receipts. Another type of record taxpayers don’t need to keep,but commonly do, is monthly statements from retirement accounts. (Whenyou begin using disbursements from such an account, you will need toreport that as income.)

When in doubt
If youhave further questions about recordkeeping for tax purposes, you canfind answers in a comprehensive, up-to-date IRS publication thatexplains what to keep, why and for how long. Download Recordkeeping forIndividuals (Publication 552) from www.irs.gov.If you have specific questions about recordkeeping or any other taxrules, consult your tax advisor or call the IRS at 800.829.1040.