I hope I get this right: tenants of the house lived in it more than 2 years, but rented it from a family member.

FM gifted it to them, and they sold it within less than a year.

FM's basis was gifted to them, and if it was a fair market value rental, the adjusted basis of the property was transferred to them, meaning less depreciation. The gift was the FMV at the transfer date. Was a 709 prepared?

The holding period doesn't transfer, so the sales price less FM's basis is the gain, short term. 

They did not live in it as owners long enough to use Sec. 121.

I hope you are not their tax advisor,  because they could have a large ordinary gain.