First, understand that you have the right to representation whenever you are required to appear before the IRS in an audit. It is in your best interest to have a reputable Enrolled Agent to represent you before the IRS. http://www.naea.org/ is a grEAt resource for finding an Enrolled Agent in your area! You can also contact us at http://www.mbtaxresolution.com/ with questions or concerns!! Going to an audit without representation is much like going to court without a lawyer.
To answer your question: You must meet the residency test of having lived in the home 2 of the past 5 years in order to claim the exclusion. If not then you will owe tax on the amount of earnings above and beyond your basis in the property. How long did you own the home and how long did you reside there? Have you agreed and signed the examination changes? Are there any other issues that have come up in the audit other than the exclusion of the home sale? So many questions that need to be asked!
The first right you have is representation. This is like going to court, you wouldn't represent yourself, so don't represent yourself in an audit. IRS Auditors are trained to scare taxpayers, and over step their bounds.
Secondly, the rule is that you have to live in the home 2 of the last 5 years, NOT own it for five years.
Craig W. Smalley, E.A.
Admitted to Practice Before the Internal Revenue Service
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