Thank you for your input.The issue I am having here is when I use
level2/item[last()], the processor considers both item elements under
<level2> as last ones. So I still get repeated <spec> elements under
both item elements.

<root>
<level1>
<st1>
<desc><text>sample desc</text></desc>
<!-- A <spec> element can occur here as well-->
<level2>
<item><text>r1 </text></item>
<item><text>r2</text></item>
</level2>
<spec><para>Some spec 1</para></spec>
<spec><para>Some spec 2</para></spec>
</st1>
</level1>
</root>

<xsl:stylesheet
  xmlns:xsl="http://www.w3.org/1999/XSL/Transform"
  version="1.0">

  <xsl:output indent="yes"/>
  <xsl:strip-space elements="*"/>

  <xsl:template match="@* | node()">
    <xsl:copy>
      <xsl:apply-templates select="@* | node()"/>
    </xsl:copy>
  </xsl:template>

  <xsl:template match="st1/desc | st1/level2">
    <xsl:apply-templates/>
  </xsl:template>

  <xsl:template match="level1">
    <step1>
      <xsl:apply-templates select="st1/*"/>
    </step1>
  </xsl:template>

  <xsl:template match="level2/item">
    <step2>
      <xsl:apply-templates/>
    </step2>
  </xsl:template>

  <xsl:template match="level2/item[last()]" priority="3">
    <step2>
      <xsl:apply-templates/>
      <xsl:copy-of select="../following-sibling::spec"/>
    </step2>
  </xsl:template>

<root>
   <step1>
      <text>sample desc</text>
      <step2>
         <text>r1 </text>
      </step2>
      <step2>
         <text>r2</text>
         <spec>
            <para>Some spec 1</para>
         </spec>
         <spec>
            <para>Some spec 2</para>
         </spec>
      </step2>
   </step1>
</root>

	Martin Honnen
	http://msmvps.com/blogs/martin_honnen/