Dear Tax Talk,
I just received a letter from the IRS stating that I have a tax increase of $7,474 for the 2007 year.

I own a few mutual funds — they are just regular ones that I pay capital gains on; these are not in an IRA or a 403(b). In 2007 I ended up taking $20,000 out of two funds.

The IRS is telling me in the letter that the $20,000 is considered income and should have been added to my taxes as such. Is this correct?

As a teacher, I had $30,000 of taxable income in 2007, but because I took this $20,000 out, I have a taxable income of $50,000 for 2007 … and a revised IRS bill of $7,474. Does this seem correct?
— Pat

Dear Pat,
As a teacher, you should know the importance of following instructions and reading carefully. The letter says you may have a tax increase. The typical IRS examination matches financial information it has received from various companies that have transacted business with you against your individual tax return.

These transactions are reported to the IRS on various information-reporting forms, typically Form 1099. A broker who has sold securities such as stocks or mutual funds reports the sales proceeds from the transactions on Form 1099-B; the “B” stands for broker.

The broker is not required and sometimes does not have the information to report the cost of the securities sold. The sales price less the cost is the net gain or loss that is taxable.

The IRS letter that notifies you of a mismatch of information is referred to as a CP2000. It is a proposed adjustment to your tax return requiring you to take action. You can agree or disagree with it. If you disagree, you need to submit more information to the IRS to establish your position. If you agree or do nothing, you will owe the tax that is proposed in the notice.

The CP2000 is quite long — usually eight to 10 pages — and may seem intimidating. In the explanation section of the letter, it will tell you the items and amounts reported that were not shown on your return.

Under the heading, “Reasons for Changes,” there should be a notation regarding the cost basis of stock sold. This section will tell you that it used a zero cost basis, as the IRS cannot determine it. It goes on to say that you should provide a Schedule D with your response. Here is a link to tax year 2007 Schedule D.

Complete Schedule D showing the previously omitted mutual fund sales and their corresponding acquisition dates and cost. You can fax these items to the IRS together with the part of the notice that says you disagree, referencing the attached Schedule D.

If you had a gain, the IRS will make the necessary changes and bill you for the balance due. If you had a loss, the IRS will even issue you a refund.

If you cannot meet the respond-by date, fax the IRS a brief letter that says you are working on obtaining the information and ask for an extra 30 days. As long as the IRS knows you are working on a solution, it will not convert the notice to a tax assessment.

Read more Tax Talk columns.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.

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