Hello,
I don't have o.dummy file so I removed that so I reduced the command to
gcc -v dummy.c 2>&1 | tee dummy-output

I noticed 3 lines there that doesn't seem make sense to me and which is probably the cause of the error

One line says ignoring nonexistent directory
"/mnt/lfs/tools/bin /../lib/gcc/i686-pc-linux-gnu/3.4.1/../../../../i686-pc-linux-gnu/include"

Well that's probably true I don't have a directory with all those /../
But if gcc was smart enough to find the path in there I don't think I would be having this problem The specs file is right after the 3.4.1 in that path
so if it says that the directory is non existent I don't see how it can find the file in a nonexistent directory

the second line says ignoring duplicate directory
"/tools/lib/gcc/i686-pc-linux-gnu/3.4.1/include"
Well if it's talking about "i686-pc-linux-gnu" then yes there is 2 of them only in the path above but in reality there is only one directory

The third line says once again ignoring nonexistent directory
"tools/lib/gcc/i686-pc-linux-gnu/3.4.1/../../../../i686-pc-linux-gnu/include"

That's just a different version of the first line

That's what my suspicion was when I first saw the /../
Is there a way to force gcc use absolute path ?

Hello,
Well I finnaly got it to work without any more errors
Aparently the /../ makes no difference because it's still the same and it's working and so are those 3 lines with the nonexistent and duplicate directory

Normally I would start from scratch but this time I decised to just delete the tools directory.
By doing that I noticed that I have another tools directory within tools
I am not sure but I assume that it's supposed to be only one tools directory
I am not sure how it happened but it had the files that were copied
at the linux-libc-headers and linux-2.6.8.1
So instead of copying it to /mnt/lfs/tools it made another directory /tools
within tools and copied the files there.
So the only thing I did differently was to put /mnt/lfs in front of those
/tools copy commands to make sure there is only one tools directory
Everything else I made the same.
So I am not sure if that was the problem but it's working now
The specfile worked and also the sanity check worked without errors so now I can go a step further
Thanks for all those who helped me out.