Ordinarily, the IRS has three years to audit you after you file your tax returns, but some returns can be audited back six years. These audits often involve real estate sales when IRS believes you omitted 25% or more of your gross income.
When it comes to real estate sales, IRS argues that taxpayers claimed excess basis for a property when it was sold, resulting in a lower gain reported. If IRS believes the gain was understated by 25% of your gross income, the sale can be audited back six years. (Hopefully you retained the records to prove your case).
Example: You sold a property for $500,000 and claimed that your basis (investment in it) was $400,000, when it was actually $300,000. That means you overstated your basis by $100,000. You reported $100,000 gain, when it was actually $200,000. If the $100,000 underreported is 25% or more of your AGI, the IRS has up to 6 years to audit and assess additional taxes on the sale.
IRS wins in court
There have been several court cases regarding this point. The IRS won a major case in the Seventh Circuit Court of Appeals. In Beard v. Com., the appellate court reversed the Tax Court and said the IRS was correct that it had six years to audit the taxpayers.
IRS loses in other court battles
Despite the big IRS victory in the Seventh Circuit, the IRS has lost in other court battles using the basis argument when it applied to real estate sales. (Home Concrete & Supply LLC v. US; Bakersfield Energy Partners LP v. Com.; Salman Ranch Ltd. v. US and Burks v. US.)
Law changed to allow IRS victory
Congress changed the ambiguity in the law that caused IRS to lose in the cases cited above. The law is now clear that an overstatement of basis is an “omission from gross income”. If omission is 25% or more of your AGI, the IRS is allowed to audit your real estate sales back six years.