I have a new client this year with a mess (a friend of course).  Looking for input on how to fix and confirm my thinking.

Taxpayer and spouse purchased rental home and formed LLC.  Filed 2553 and S election accepted by IRS.  After doing all of this they asked if it was a good idea...Purchased home for approx. 137k subject to mortgage of approx 103k.  Initially I had planned to file an initial and final s corp return and distribute the property out at FMV by reporting the "sale" on Form 4797.  I thought this would essentially result in them recapturing the depreciation.  However upon further review, looks like the mortgage will cause an issue.   Since the contributed property is subject to a liability, it appears their basis in S corp stock is reduced by liability.  Based on above numbers their stock basis would be approx 34k (137 - 103).  They will have a small rental profit.  The FMV at year end was 135k so if they distribute that out, they would have a distribution in excess of their basis to the tune of 101k (135 FMV - 34k stock basis).  Can anybody confirm with the above analysis?  Any idea on how to get the property out without incurring a large gain?  My hope was to get them filing a 1065 next year and going forward (SMLLC would have been my recommended approach if they insisted on an LLC).  The issue with keeping it in the S Corp besides inflexibility is the payroll - or lack thereof.