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the legal workaround for the frequency test for married couples is that if each spouse owns a home that meets the ownership and use tests and each meets the frequency test - have not used the HSE in the two years ending on the date of sale of their home, each can exclude up to $250K
"My wife co owned a house with her sister as their primary residence for 2 years before we were married. She moved out and rented it for 2 years."
assuming rental at Fair Market Value, even if to her sister, under the tax laws it should have been depreciated. depreciation reduces her tax basis in the property. in these cases when a personal residence that was a rental is sold for more than its tax basis, even if it meets all the exclusion rules, first the depreciation must be recaptured as section 1250 gain. then and only then is any remaining gain eligible for the HSE
if it was rented to her sister at less than FMV, then it is treated solely as a personal residence and not as a rental so no depreciation would have been allowed.