For example year 0 cash outlay is -1000
year 1 cash inflow +500, year 2 +700 when calculating IRR on these three year cashflows should one add a terminal value to the cash inflow of year 2 ? Which terminal value can be estimated using year 2 cash inflow as well ?

Yes, the existence of a terminal value implies that the asset or security has some positive value remaining immediately following the 700 Y2 inflow. It might be (a) the market value at such time, or it might be (b) the PV of any remaining expected cash flows (and of course (a) should = (b)). In any case, a good IRR calc will include this value just as if it was a Y2 inflow as well.