How Many Years Does the IRS Have to Audit My Tax Returns?

by Tom Buck

Until recently the IRS could audit your filed tax returns for three years. This is calculated from one of two dates – three years from the due date of the return (including extensions) if the return is filed on time OR three years from the actual date it was filed, if it was filed late.

However, if your gross income was understated by 25% or more, the three years turn into six years. Previously, this additional three years did NOT include the possibility that you sold an asset (stocks, bonds, business equipment and the like) and understated your basis in the asset. Now it doesn’t matter the source of the under-reported income, so it applies to ALL income sources, including gain on sale of assets.

Before we get into the specifics here, I’d like to explain the term “basis” in a tax context. Basis is the cost of the asset when you bought it, plus any additions or improvements you made to the asset, less the total depreciation you have taken over the years.

Let’s say you bought a piece of business equipment, say a tractor (since I live in farming country this is a very common purchase) for $120,000. Later you purchased an additional blade for the tractor for $5,000. Your basis before depreciation would be $125,000. Assume that depreciation over the years amounted to $40,000. This would leave a tax basis of $85,000 ($125,000 less $40,000).

In Iowa I have been seeing something unusual lately. Farmers often have been able to sell used equipment for more than the original purchase price. Let’s assume you sold the tractor and blade for $140,000. The gain for tax purposes would be $55,000 (sale price $140,000 less basis $85,000). If you reported this correctly on a timely-filed tax return, the IRS would have only three years to audit the return.

Now let’s assume that, in the process of gathering all information for your tax return, you somehow neglected to adjust the basis for the effect of depreciation. In this case you would report the sale at $140,000 less the basis of $125,000. So here you would report a gain of $15,000 (sale price of $140,000 less the [erroneous] basis of $125,000).

Instead of $55,000 gain, you would have under-reported your income by $40,000, the amount of depreciation you forgot to include. If your total income was $150,000 then 25% understatement would amount to $37,500, so you under-reported your income by more than 25%. That would allow the IRS an additional three years to audit the tax return for this year.

A more common circumstance is with stocks and other paper investments. Say you bought shares of stock many years ago and sold them this year. You can’t remember what you paid for it, so you guess at the cost. If you guess badly and the result is that you under-report the gain you could end up with that 25% understatement of income, in which case you will have given the IRS an additional three years to audit.

Look at this scenario. You inherited the stock. When an asset is inherited, the recipient gets the benefit of a “stepped up” basis. This means that whatever the fair market value (FMV) was on the date of death of the benefactor becomes your basis. If you take the trouble to determine the FMV as of the date of death, you should have no problem reporting the taxable gain (or loss) correctly.

But here is a situation that causes problems for some folks. If you received the shares as a GIFT, your basis becomes whatever was the basis of the person who gifted the stock to you. As you might imagine, there could be a huge difference in  basis compared to the basis if it were inherited.

The problem that arises here is this: What if your benefactor doesn’t know what was paid for the shares? Now you are guessing at what your basis should be. If you miss by more than the 25% we have been discussing, you could be giving the IRS that additional three years to audit.

I recently had a farmer client who sold some land. Part of it he had purchased and some of it was inherited. Of course, he had no problem calculating the basis on the land he had purchased. However, things got much more confused regarding the basis of the inherited land.

In this case, he inherited the land upon the death of his mother. She had inherited some of the land as a result of the death of her husband – no problem yet because it is usually possible to determine FMV for this part of the land. However, the rest of the land had come to Mom as a result of a gift from her brother.

Mom’s basis in the land her brother gifted her should be what her brother’s basis was. Mom did not find out what her brother had paid for this parcel. Obviously, this created a basis problem.

Sometimes you just have to do the best you can with the information available. My attitude has always been: If we have honestly done everything possible, using all available information, we have to go with it. If the IRS thinks they can come up with a better answer, fine, but they will need to show us how they arrived at their conclusion before we accept their result rather than the one we calculated.

As a practical matter, unless the dollar amounts are very large and the IRS has some reason to inquire into how the calculations were made, it is not likely that the return would end up being subject to the additional three years audit period.

The best advice I can give you is to be as honest as you can in helping your tax preparer come up with an accurate calculation of basis. There are circumstances in which this is the best you can do. Once you have done your best, you should be able to sleep well.

Please remember us to folks you might know who are having IRS problems: We defend our fellow citizens against their government by making sure the IRS obeys the rules.