For purposes of the exclusion rule, everything that happened before the gift deed in 2021 doesn't matter (it resets the clock). However, that will definitely affect your cost basis. So I will discuss the exclusion rule and the cost basis separately.
First, you don't qualify for any exclusion until you have owned the home for 2 years and lived in it as your main home for 2 years starting from the gift deed in 2021. Then, if the home is currently a rental, and you then move in to use it as your main home, the fact of there being a non-qualified period of ownership before the qualified period of ownership triggers a special set of rules. Let's say the tenant's lease ends in 6 months and you move in, live there for 3 years, and sell. You would have 6 months that is considered non-qualified and 36 months that is considered qualified, so only 36/42 or 85% of the gain is qualified. You would pay gains tax on 15% of the gain, then 85% of the gain is applied to the exclusion rule. Let's say your gain is $300,000. The first $45K is taxable, the next $250,000 is excluded, and the last $5K is taxable (if you are single or head of household and not filing as married filing jointly). If you lived in the home as your main home for 5 years, the 60/66th of the gain, or 91%, is excludable, and so on.
Now, to actually figure your gain, you have to know the cost basis, and this is where the ownership history is critical.
As of 2010, your cost basis in your half of the home was $100,000 and your sister's basis was $100,000.
As of 2012, when you gave your half-interest to your sister, you gave her your basis. So your sister's basis is now $200,000.
As of 2021, when the property is gifted back to you, your basis is your sister's basis which is $200,000, unless your sister made improvements that can be added to the basis.
However, you or your sister were eligible to deduct depreciation on the rental, and that must be accounted for even if you didn't actually take it. That should be about $36,000 at this point. You should get copies of all your sister's tax returns, or at least the depreciation schedules, so you have records of the depreciation taken.
If you sell the house now, your adjusted basis for the sale will be your basis ($200K) minus depreciation. If your selling price is $500K, your gain is $336K. The first part of the gain, which is due to depreciation, is taxed as depreciation recapture, which is taxed as ordinary income with a cap of 25%. Then the remaining $300,000 gain is taxed as capital gains. If you own less than 1 year, it's short term capital gains and if you own more than 1 year, it's long term capital gains.
Now finally let's integrate these two concepts. Suppose you move into the home after the tenant leaves and live there 3 years, and you sell for $600K. Your capital gain is $436K. The first $36K is taxed as depreciation recapture (you must always recapture the depreciation first). Your remaining gain is $400K. You are eligible to use the exclusion on 85% of the gain, which is $340K. Since that is more than $250K, you use the full $250K exclusion, and the last $150K is taxed as long term capital gains. If you are married, you can exclude the full $340K that is eligible for the exclusion. and you would have $60K of long term capital gains.
Hope this helps. I agree you will want to engage a tax advisor, sooner is better.
