Thank you all for the feedback.

My reading of this is that "1 sale within 2 years rule" overrides all else, and we need to report gain on house 2. Even though house 1 sale was not reported as it did not need to be reported. 

Further wrinkle. House 2 joint owned by clients adult daughter (separate taxpayer) who lived in the house in aggregate for 2 years while completing her studies. 

Thoughts on using daughters exclusion for 50% or whole gain for sale of house 2? 

Thanks Nolan