Also note that in tax law, there is no such thing as innocent until proven guilty. All your income is presumed taxable unless you can prove otherwise. As the Tax Courts have stated many times, “deductions are a matter of legislative grace”, and the taxpayer has the burden of proving that a deduction exists in the law and that they qualify for it. In other words, if your child sells a home for $400,000 in my example, the entire amount is presumed taxable unless they can prove they are entitled to a basis adjustment (on the basis of the gift and your prior depreciation) and they can also prove they qualify for an exclusion under the 2 year rule. That gives the IRS all the authority they need to investigate whether the events that gave rise to the adjustments actually happened.
