How long do you have to keep your tax records? The usual answer is at least three years, but there may be extenuating circumstances.
In a new, unpublished decision handed down by the Fourth Circuit Court of Appeals, Forde, CA-4 No. 18-1584, 11/13/18, a taxpayer would have saved a significant amount in taxes if he could have produced records for certain home improvements. The Fourth Circuit affirmed the Tax Court’s decision without further discussion.
The traditional three-year rule is based on the length of time the IRS has to review your personal income tax return. Generally, the statute of limitations for an audit is three years from the filing due date. But the IRS can go back as far as six years to assess additional tax for an omission of more than 25 percent of the amount that was due. And there is no time limit if fraud is involved.
Also, keep in mind the usual three-year limit only applies if you actually filed a return. The statute of limitations doesn’t officially start to run until the IRS has the document in its possession.
So, what sort of circumstances would warrant holding onto tax records longer than three years? Well, you might advise a client to do this when they sell a house where the basis for gain purposes can be increased by the cost of home improvements.
In the new case, the taxpayer and his spouse purchased a house for $835,000 in 1998. Over the next three years, they demolished the main residence and built a new one. He lived in this “guest home” while it was being renovated.
During this time, the taxpayer owned an online tutoring company that was being investigated by the Securities and Exchange Commission (SEC). He was sued by the agency for making false and misleading statements and omitting material information in securities filings.
As a result of this lawsuit, the taxpayer was in danger of losing the home and was unable to refinance his mortgage. After filing for bankruptcy, he arranged for a sale in 2002.
The contract called for a sales price of around $3.9 million. But it was later determined this was part of a mortgage fraud scheme. The supposed buyer never took possession, nor were any payments ever made to the taxpayer.
Eventually, the mortgage went into default, and civil and criminal actions were brought against the taxpayer. He was convicted in 2009 and sentenced to 42 months in prison.
The taxpayer finally filed his 2002 income tax return in 2012 – nine years late. He didn’t report any gain from the sale of the residence and claimed that his basis in the home exceeded the amount realized from the sale. But he could only provide proof of his original purchase price and a small amount for home improvements. He didn’t have any other documentary proof of the increase in basis that he claimed. The IRS used the sales price of $3.9 million to calculate the taxable capital gain.
Here’s the moral of the story: It is important to keep records of home improvements and similar expenses that can reduce a taxable gain if you are ever audited. Impart this valuable information to your clients. Encourage them to contact you about which records they should keep for longer than three years and which ones they can toss out before they do anything.
Ken Berry, Esq., is a nationally known writer and editor specializing in tax, financial, and legal matters. During his long career, he has served as managing editor of a publisher of content-based marketing tools and vice president of an online continuing education company. As a freelance writer, Ken has authored thousands of articles for a...