Don’t Be Too Quick to Toss Old Tax Records
I was asked to assist with an appeal of an IRS examination of a real estate investor. One of the big issues was that the IRS denied $500k in losses from prior years outside the audit. In case you are curious, the taxpayer was hit hard, like most people, during the 2008-2010 crash and its aftermath. Unfortunately, the IRS demanded substantiation for these losses, but it appears the taxpayer discarded those records and so his losses were denied. In talking with him and his accountants, we may have only limited documentation and so he may be unable to resurrect these losses upon appeal.
I used to be a CPA handling tax preparation and I often parroted the old line that tax records should be kept for 7 years. Unless it involved real estate or large asset purchases. In those cases, you would keep those records for seven years after the sale/disposition of the asset. As you will see in a moment, that sage advice misses a very big hole.
IRS Audit Assessment Period
Audits and examinations by the IRS usually have to occur within 3-6 years of filing (with no limit on unfiled or fraudulent returns). Once that period passes, the IRS is unable to assess additional taxes for that tax period. So why then did the IRS deny a loss carried over from prior years, over a decade in fact? The answer is simple. The IRS is always allowed to require substantiation for items that impact a year under audit, which includes losses carried from a closed tax year. If the taxpayer cannot prove up the claimed loss or deduction, then the IRS can deny that loss or deduction.
Here’s the rub, most taxpayers do not keep boxes of records around for years on end. Providing the auditor with tax returns alone is not enough to support the claimed loss or deduction. These returns are considered a taxpayer’s position and are not “proof.” Accountant’s workpapers also suffer the same infirmity. What the taxpayer needs to provide are copies of all documents that show that a tax loss was incurred for that year. Think bank statements, financial statements, receipts, invoices, etc.
Most taxpayers – regarding older tax years – may keep copies of tax returns in a file cabinet somewhere and, if you are lucky, a stray bank statement here or there. Often, they throw much of their tax stuff out after 6-7 years – once they feel pretty sure the IRS won’t audit them. You can see how this boomerangs back on them in cases like this. The worst part is that the IRS does nothing to put taxpayers on notice of this maneuver.
The IRS’ Position Generally on Tax Records
The IRS tells taxpayers to keep tax records using the following guidelines:
- Keep records for 3 years if situations (4), (5), and (6) below do not apply to you.
- Keep records for 3 years from the date you filed your original return or 2 years from the date you paid the tax, whichever is later, if you file a claim for credit or refund after you file your return.
- Keep records for 7 years if you file a claim for a loss from worthless securities or bad debt deduction.
- Keep records for 6 years if you do not report income that you should report, and it is more than 25% of the gross income shown on your return.
- Keep records indefinitely if you do not file a return.
- Keep records indefinitely if you file a fraudulent return.
- Keep employment tax records for at least 4 years after the date that the tax becomes due or is paid, whichever is later.
List from IRS blog post on records retention: How long should I keep records? | Internal Revenue Service (irs.gov)
You can see that nowhere in this list does it say that you should keep records related to losses or other deductions carried forward from prior years. Honestly, I suspect the IRS employee who wrote this up was not aware that the IRS can examine closed years. If they did, I would think it is a disservice to taxpayers to omit that information – ostensibly the IRS is here to help educate taxpayers.
Not all blame falls on the IRS’ shoulder though. Tax preparers, my former self included, did not deal with many IRS audits (IRS audit rates are some of the lowest in its history) and so these issues never bubble up. With more audits, I think the issue would be more front and center when advice is dispensed regarding records retention.
In Summary – How Long Should I Keep Tax Records?
My advice to taxpayers now is to keep records indefinitely. With scanners and low-cost cloud storage, there is no reason not to keep complete records for each tax year. You do not want or need to find yourself in a situation as this real estate investor.
It may strike us as fundamentally unfair to play “take backsies” with tax years closed to audit but that is the rules we have to play by. If you do find yourself in this situation, just remember tax returns are not enough nor is your accountant’s workpapers. You will need to provide other proof in the form of documents and other evidence to support your position (beyond your own testimony). If you can then you may be able to save some, or all, of these carried forward items.
I am Maine’s IRS Problem Solver. My firm helps Maine taxpayers in trouble. If you or someone you know in Southern Maine wants more information on how to resolve your unpaid taxes, please feel free to contact me directly at 207-502-7181 or by filing out my contact form. A Maine tax attorney can help you consider your options.