Q. If my child uses the property as their primary residence (for at least two years), do they owe any taxes on the gift (capital gains, income, gift tax, or otherwise)?
A. No. As others have said, a gift is not taxable to the recipient. How long they live in it is irrelevant, for whether the gift is taxable.
Q. When my child eventually sells this primary residence, and they lived in it more than 2 years, will they owe taxes (capital gains, income, gift tax, or otherwise)?
A. Yes. They will owe capital gains tax and tax on the depreciation recapture (section 1250 gain). But, they will qualify for a prorated home sale exclusion. The gain will be prorated between the residence time and the rental time (even the time before they owned it). Only "non qualified use" after 2008 is prorated. Deprecation since May 6, 1997 must still be recaptured, even in a home sale exclusion situation. The recaptured depreciation is not included as a part of the exclusion calculation.
For details see a similar question at:
https://ttlc.intuit.com/community/tax-credits-deductions/discussion/re-gifted-rental-property/01/173...
Q. There was some talk of a "sham" to avoid taxes.
A. Any sham you can think of, the IRS is already aware of it and has written rules for it. In this case, the new owners only get to exclude the amount related to their limited residence time. Tax is still due on the rest. There is no "sham" in your case.
