Hello JA Customer,
The IRS does not allow taxpayers to claim a deduction for mortgage interest unless they are an equitable owner of the property. If you continued to claim a portion of the mortgage interest on the home after you sold the property to your sister, then that was not a legal deduction.
The fact that you claimed a deduction for the mortgage interest is likely why the IRS believes you still owned the home during those years. The only thing you can do in this situation is to provide the IRS with copies of the sales documents showing the home was sold to your sister back in 2006. If you can prove to them that the home was sold more than 3 years prior to your new home purchase, they should allow you the homebuyer credit. However at the same time they will likely require that you amend your returns for the 3 years where you claimed mortgage interest as a deduction when it should not have been allowed. You would end up owing back the additional taxes due for those 3 years as a result of this change, along with interest and penalties associated with the underpayment of the tax. In addition to this issue, if your sister has not been claiming the amount you were paying as rental income on her own return, this could also cause the IRS to audit her returns for those 3 years and have her claim the additional income she received from you renting the home. So you really need to weigh the possible consequences here to see if it is still worth it to you to try and claim this credit.
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Thank you JA Customer