@Opus 17 wrote:
I don't see that as being an answer to whether the gain is subject to the non-qualified use rules under §121(b)(5), because section (b)(5)(B) only talks about ownership by the taxpayer, and not holding period. Certainly the brothers would have their father's cost basis, including depreciation to deal with.
There is a concept known as "tacking" that covers the holding period, so the brothers take their father's holding period. Depreciation deductions will devolve to the brothers and the basis will, most likely, be a carryover basis (i.e., their father's adjusted basis).
Since, as a result of the gift, the brothers will take their father's basis, holding period, and depreciation deduction (recapture liability), why would it not follow that they would also have to take their father's type of use into consideration? Is there authority stating otherwise?
If the nonqualified use did not follow (the gift) to the donee, that would be a great tax dodge for a donor with a large period of nonqualified use (as well as the donee, of course). The IRS (and Congress) probably did not intend for that to be the result of a gift of rental property with nonqualified use but, rather, that the donee step directly into the shoes of the donor (i.e., the brothers would follow your first scenario).
