If you sell house #2, and you have owned and lived in house #2 for less than 2 years, you can use a partial exclusion by reason of hardship. Note that the tax law doesn't actually say "hardship", it says "such sale or exchange is by reason of a change in place of employment, health, or, to the extent provided in regulations, unforeseen circumstances". Unforseen circumstances are covered on page 4 here, if you believe you have an unforeseen circumstance that will give you a partial exclusion, keep good records in case of audit.
I think you would also qualify for the partial exclusion if you converted to a rental as long as you sold within the next 3 years -- if you hold it longer than 3 years, you would lose the ability to use the exclusion based on the regular 5 year rule. (The unforeseen circumstance rule doesn't give you a blanket exemption -- it only means that if the *only* reason you don't qualify is because of not living there 2 years due to a qualifying circumstance, you can use a partial exclusion. If you fail to qualify for other reasons, like the 5 year rule, you can't use the hardship rule to get around it.) If you held the property for less than 3 years and qualify for the exclusion but for the two year rule, I don't see a ban o
