A question I’m asked every year is how long should I keep my tax returns? And how long should I keep the backup documentation for the returns? The first question is easy to answer; the second one isn’t. (James Maule’s post on this subject reminded me of this issue.)
To start on this determination, we need to look at the statute of limitations. That is generally three years from the due date of the return or date of filing (whichever is later) for federal returns. However, it doubles to six years if there’s a gross understatement of income. For your 2012 taxes timely filed, that would be either April 15, 2016 or April 15, 2019. Most states give their tax agencies an extra year for the statute of limitations, so if you live in a state with state income tax that means four or eight years from the due date of the return or date of filing (whichever is later). So you can ditch the returns after eight years, right?
Wrong. I strongly recommend you keep your tax returns–and proof of filing–forever. There is no statute of limitations if you don’t file your return. A few years ago, one of my clients was accused by a state tax agency of not filing his 1977 state tax return. Yes, 30 years after that return was likely filed the state came to him and said he didn’t file the return. They accused him of owing a couple thousand dollars of tax, and a lot more in interest and penalties. My client did have his federal tax return, and we were able to find enough records to show that he was owed a refund by the state for 1977. (Most likely, the 1977 state return was filed and the state tax agency’s records got messed up.) Had my client kept his state tax return he would have been able to send a copy to the state and saved himself a lot of aggravation and fees.
Well, at least I can shred all my backup documentation after six or eight years, right?
Perhaps. If you don’t have any investments, any items with basis calculations, or any similar items, yes, those items can be disposed of after six or eight years. For example, a sole proprietor’s travel receipts can be shredded at that time. However, there are many receipts and records that need to be kept for far lengthier periods. Let’s look at some examples:
1. You bought a stock in 1992. You sell it in 2014. You claim a capital loss on your shares of the stock. The IRS examines your return and alleges that you didn’t have a loss; rather, you made a large profit. Wouldn’t you like to have proof of your purchase price?
2. You purchase a rental property in 1998. In 2007, you use a Section 1031 exchange to defer the gain on sale of that property (by purchasing another property through a qualified intermediary). In 2013, you use another 1031 exchange. In 2020, you sell the property that you ended up with. You need proof of your basis in the property. That means you will need the HUD Settlement Statement on the purchase and sale of all the properties. If you made improvements to the properties, you need those receipts. Depreciation records will be needed. If in 2002 or 2006 you disposed of the records of the original rental purchase, you may have a problem.
3. You purchase a boat in 2002 for $50,000. You retire in 2013; your taxable income is now quite low (you have nontaxable income from municipal bonds). In 2014, a drunken boater rams and destroys your boat. Unfortunately, you only receive $25,000 from your insurance company. You claim a casualty loss on the damage to your boat for $25,000. The IRS denies the loss in an audit. If you don’t have records showing the purchase price of the boat (your “basis”), the IRS will likely win in Tax Court.
I can go on with similar examples–these three were ones I quickly thought of. If you are certain that a situation like any of these won’t apply to you, shred away! Unfortunately, I suspect most of us have items like these (especially clients of tax professionals). If so, keep those records.