What to do with your tax records?

When it comes to tax paperwork, many people are adamant about keeping every scrap of paper, often believing those documents will save them if the Internal Revenue Service comes knocking. But that's not necessarily the case. Bankrate.com tax writer Kay Bell has these tips on how to sift through piles of tax-related documents and keep only the ones you really need.

When it comes to tax records, says Bell, you should hang on only to those that help you identify sources of income, keep track of expenses, determine the value of property, prepare tax returns or support claims made on those returns. This means 1040 forms and any accompanying tax schedules, along with the documents supporting the return, such as W-2s, 1099 miscellaneous income statements and receipts or canceled checks verifying tax-deductible expenses.

But don't go overboard. If you used something to claim a deduction, keep it -- if not, shred it. For example, hoarding medical bills is useless if you didn't accumulate enough to meet the deduction threshold. Let common sense, as well as storage space, be your guide.

To be sure, some items do have a longer shelf life. These generally are assets that a taxpayer will eventually sell, triggering a tax bill. So if you have a pension plan, own a home or invest in the stock market, tax pros recommend keeping these records indefinitely. At the very least, you should keep them until three years after you dispose of the asset.

As far as how long you should hold onto tax papers, the rule of thumb is until the chance of audit passes. Usually, this is three years after filing. But if the IRS suspects you underreported your income by 25% or more, it gets six years to check into your tax life. That's why most accountants advise taxpayers -- even those who are meticulous filers -- to keep tax documents for six to 10 years.

Since for most taxpayers the biggest asset it their home, it's important to understand the rules governing profits from home sales. While the tax rules have changed in recent years, meaning sale profits don't automatically face IRS charges, any paperwork relating to a residence should be kept for as long as the home is owned.
Single home sellers now can net capital gains of $250,000 (double that for married couples) before owing the IRS. To determine whether sale profits fall within the tax-free limits, the seller must accurately establish a residence's basis. That means that records related to a home's value -- settlement papers and receipts for improvements and additions -- are critical.

If you sold a house before May 7, 1997, that could affect your current home's basis. With home sales back then, taxpayers were able to defer tax on any gain by using the profit to purchase another home and filing IRS form 2119. If the home you're now selling is the one your pre-1997 sale proceeds were rolled into, you'll need those old forms to figure your current property's basis and any potential tax bill.