GAIN ON SALE OF PRINCIPAL RESIDENCE

Charlie and his wife lived in the house for the last 15 years. In 2010 due to some unknown reasons, he demolished the house and constructed house on the same lot. The house was completed in 2011 and decided not to stay in the same house. He sold the house in 2014 at gain of $547,000. He excluded gain of $500, 000 (exclusion allowed for MFJ) and paid capital gain on $47,000. He was audited for 2014 and IRS had a different idea.

1. what is wrong with this case?

2. what should be done to help this client?

3. what is the IRS going to do?

4. does this client qualify for exclusion? If so how much? why?

5. Is the gain from the sale need to be reported? why?