For many financial documents, just 3 years — for others, practically forever

You may be starting at a heap of paperwork when you finish filing your 2021 federal taxes, which are due April 18. Your first urge may be to sweep them all into a paper bag and put the bag under a stairwell. Don’t do that. Instead, keep only the records you need to keep. And that starts with sorting them out.

Try to stay tidy

Neat, complete, well-organized financial files speed the process of filing your tax return and can keep you from making errors. Maintaining some semblance of order after you’ve filed your return — rather than tossing it into a file cabinet or shoebox — will come in handy if the Internal Revenue Service has questions about your form.

“The biggest blunder is not being organized about what records ought to be kept,” says Neal Stern, CPA, a member of the American Institute of CPAs’ National CPA Financial Literacy Commission. “There are people who somehow believe that they should keep all of their paperwork, but they don’t think through what the important paperwork is that should be kept or how it should be kept or how it should be organized.”

People who keep too many financial papers often struggle just as much to find needed documents as those who don’t keep any files. “They end up having drawers full of old papers,” Stern says. “It’s not much better than not having the paperwork if you can’t figure out what you have and where it is.”

What to keep

For an individual tax return, you’ll need to save anything that supports the figures you entered on your return. You should keep the W-2 and 1099 forms you get from employers, for example, as well as any 1099-B or 1099-INT tax documents from banks, brokerages and other investment firms.

If you lost your job last year and received unemployment benefits from the government, be sure to keep your 1099-G form, which reports the amount you have received. The government is gave a tax exemption of up to $10,200 of unemployment income ($20,400 for married couples filing jointly) received in the 2020 tax year, but that exemption disappears for the 2021 tax year, so you’ll owe federal income taxes on the entire amount.

If you’re itemizing your deductions, keep receipts for these: credit card and other receipts, invoices, mileage logs and canceled checks. If you’ve bought or sold mutual fund shares, stocks or other securities, you’ll need confirmation slips (or brokerage statements) that say how much you paid for the investments and how much you received when you sold them. Keep a copy of all your investments for at least three years after you have sold them.

Similarly, if you’ve sold a home, you’ll need records that prove what you paid and what you received from its sale. And if you’ve sold a rental property, you’ll need detailed records of the amount you’ve invested in the property over the years, as well as how much you deducted for depreciation. It’s wise to keep Schedule E, the form you fill out every year for rental income, as long as you own the property.

How long to keep it

You’ve likely heard that seven years is the perfect period to hold on to tax records, including returns. The actual time to keep records isn’t that simple, according to Steven Packer, CPA, in the Tax Accounting Group at Duane Morris.

“In most cases, tax records don’t have to be kept for seven years because there’s a three-year statute of limitations,” Packer explains. “So assuming there’s no fraud or nothing else wrong, the IRS cannot look at your tax returns beyond that three-year statute.”

The statute of limitations has some important exceptions, and if your tax return has any of these, you’ll need to keep your returns and your records longer than three years. For example, the statute of limitations is six years if you have substantially underestimated your income. The threshold for substantial understatement is 25 percent of your gross income. If you claim your gross income was $50,000 and it was really $100,000, you’ve substantially understated your income.

The six-year rule also applies if you have substantially overstated the cost of property to minimize your taxable gain. Say if you sold a piece of property for $150,000 and claimed you paid $125,000 instead of the actual $50,000, the IRS has six years to take action against you. And if you have omitted more than $5,000 in income from an offshore account, the statute of limitations is also six years.

Keep records for seven years if you file a claim for a loss from worthless securities or bad-debt deduction. If you haven’t filed a return, or if you have filed a fraudulent return, there’s no statute of limitations for the IRS to seek charges against you.

Property records can be forever

When you sell a property at a profit, you’ll owe capital gains tax on that profit. Calculating your capital gain often requires you to hang on to your records as long as you own your investment. You’ll need those records to calculate the cost basis for the property, which is the actual cost, adjusted upward or downward by other factors, such as major improvements to the structure.

Calculating the cost basis on property you live in is relatively simple because most people can avoid paying capital gains tax on their primary residence. If you sell your primary residence, those filing individual returns can exclude up to $250,000 in gains from taxes, and couples filing jointly can exclude up to $500,000. You must have lived in your home for at least two of the past five years to qualify for the exclusion. Even so, you’ll need to save your records of the transaction for at least three years after selling the property.

If your sale doesn’t meet the above criteria, you’ll need to keep records of significant improvements for at least three years after the sale. IRS Publication 523, “Selling Your Home,” spells out what improvements you can add to your cost basis — and reduce your capital gains bill. The same holds true for rental property.

Most brokerages will compute your cost basis for stocks, bonds and mutual funds, although they are only to calculate your cost basis for stock transactions since 2011 and mutual funds since 2012. It’s a good idea to keep all your transaction records, however, in case you change brokers. Your broker is not obligated to hold your records indefinitely. In addition, keep records of any inherited property and its value when the owner died, which will become your tax basis.

There’s nothing wrong with saving your records longer than the legal limits if it gives you peace of mind and you can stand the clutter. You might consider storing some records in the cloud — remote computer storage space that you rent.

Although many people keep paper records, it’s also smart to have the documents converted to electronic files and stored in the cloud. It’s a good idea to have two sets, in case one is destroyed. Finally, remember that your state may have separate rules for keeping records; check with your accountant or state tax department.