I would answer "Yes, I will meet these conditions" and leave it at that. There is nothing to manually edit on the Form 8889. The instructions in IRS Pub 969 are derived from IRS Notice 2008-51 which includes, "The qualified HSA funding distribution is included in gross income in the taxable year of the individual in which the individual first fails to be an eligible individual. This amount is subject to the 10 percent additional tax (unless the failure is due to disability, as defined in § 72(m)(7), or death)." This part of Notice 2008-51 derives from section 408(d)(9)(D) of the tax code: <a rel="nofollow" target="_blank" href="
https://www.law.cornell.edu/uscode/text/26/408#d_9_D">https://www.law.cornell.edu/uscode/text/26/408...>
TurboTax's is simply asking wrong question. Instead of asking if you will remain an eligible individual throughout the testing period, TurboTax *should* be asking if you remained an eligible individual through the end of 2016. If not, you include the income and pay the penalty with your 2016 tax return. If you remained an eligible individual throughout 2016 but failed to remain an eligible individual throughout the remainder of the testing period in 2017, as in your case, the income and penalty are to be reported on your 2017 tax return.
Regarding reporting this as a regular distribution, a Form 1099-R includes no indication that the distribution was an HFD. An HFD is reported on Form 1099-R the same as any regular distribution from your IRA. The only thing that makes the direct transfer to the HSA an HFD is the reporting of an HFD on your tax return. Nothing prevents you from treating it as a regular, non-HFD distribution and separate HSA contribution instead.
