I've been through all this before, several years back. For every rule there are exceptions and things that don't apply, other things that do apply. I'm not going through all that research and back and forth again. I'm just getting to old for it. You report the sale based on what you actually paid for the property plus what you actually paid for property improvements. Now of course, you can report however you want. I'm confident that the IRS will have no issue with you reporting based on the lesser FMV of the property, as that's more of any gain they get to collect taxes on.
You report (in your case) in the investments section, because rental property *is* investment property/business property.
Now if you want to go ahead and report it in the rentals & Royalty Income section (which BTW is what I do since my depreciation values and original purchase values match anyway on my rentals) you most certainly can.
I've seen where some have changed the values in the assets/depreciation section for the asset, and I can tell you that's a sure fire way for an audit 24-36 months down the road. Changing asset values affects not only the current year's depreciation, but it also sticks out like a sore thumb throwing what your depreciation "should" have been in prior years based on the changed value.
