Apparently you were issued a Form 1099-S for the sale of the home. The IRS also received a copy of the Form 1099-S for the home sale and expected to see this sale reported on a Schedule D and Form 8949 with your personal tax return.
If you sold your primary personal residence and you lived in and owned the home for at least two years in the five year period on the date of sale, you do not have to report the sale if your gains are less then the exclusion amounts of $250,000 if filing Single or $500,000 if filing Married Filing Jointly (and both lived in the home for two years).
If you had a gain greater then the exclusion amounts then you would have to report the sale. Also, if you received a Form 1099-S for the sale either with a gain or a loss, the sale has to be reported.
Although you may no taxes on the sale of the home, with a Form 1099-S issued you must report the sale, gain or loss, on your tax return.
You need to contact the IRS using the phone number on the notice you received, explain the situation and see if they want you to file an amended tax return.
Gain or Loss = Sales Price (-) Sales Expenses (-) Adjusted Basis of the Home (Purchase Price + cost of improvements prior to the sale)
Mortgage payoff is not a factor in calculating a gain or loss on the sale of a personal residence.
