Capital Gains Question

[Curtis H.]

Hello all, 

Interesting scenario where I'm curious what the tax implications would be. 

Sister puts house in her name for a sibling, lives in it for the first 3 years, then moves out. Sibling continues to pay mortgage for the next 7 years, creating a $500K equity spread. Sister surprises sibling by saying "this is my house now, even though I said I was doing this as a favor, and I want half the equity despite not putting a penny into the house". 

House gets sold, and the sister gets an equity check for $500K, which she then has to cut a check for $250K to the sibling. 

My questions are...

1) Does the sister have to pay capital gains on $500K since she did NOT live in the house 2 of the last 5 years leading up to the sale? 

2) If the sister writes a check to the sibling for $250K, can she report that to offset her gains? Or is that not a justifiable expense? Sibling is worried they will get hammered on the $250K check from sister. 

Thanks!