I agree with @Anonymous_ that since your spouse never used the property as a principal residence she would not qualify for the home sales exclusion. the complex question is that of ownership. since the original title transfer was invalid does the new titling result in ownership taking in the year it occurred or in 2012. there may even be different answers for income tax and non-income tax purposes.
the IRS could take the position that ownership by your wife's sister did not occur until the title was properly transferred. this would mean her sister did not own the property for the required two years before the sale and thus is not entitled to any home sale exclusion.
there is also the question of who was entitled to deduct the real estate taxes and mortgage interest if there was a mortgage.
