re8888 is about right.

you need to depreciate your rental property every year. you have to use the lesser of the fair market value of $800K or the adjusted basis for the house (the $400K purchase price + other purchase cost + any additions to the house if any) on the day you converted your residence to rental property in 2007. In your case, you have to use the latter, i.e. $400K +, not $800K for depreciation basis.

Thus, you do have gain when you sell it for $800K.

This also answers the question about how IRS knew the value. You need to depreciate your rental property.