This was definitely horror to me, as Jesse said, more in the style of a Poe tale than some others. Which is fine with me because I like Poe.
Interesting that this played so near "A Study in Flesh and Mind" which had some common roots in the myth that "art is suffering". By saying it's a myth, I'm not saying that suffering can't produce great art, only that suffering need not be necessary for great art. All that myth really accomplishes is convincing artists that they need to torture themselves.
Anyway, I enjoyed this story a lot. I hadn't quite seen the ending coming, though I feel like I should have. It got really interesting when I realized what the mentor had meant about his student not suffering much. When I'd originally seen it I'd thought the mentor was being a hypocrite and I wondered what he thought he had endured that was really so terrible, but that wasn't what he was saying at all. He has someone else to suffer FOR HIM, and that's how his work gets to be so compelling.
I didn't think the ending was out of character at all. He's shown his lack of boundaries and obsession by breaking into the house in the first place, and when he finally realizes that Toy is the source of the fiction, he does not think "That poor creature!" or "My mentor is a sadist, and worse, a plagiarist!" he thinks "That should have been me!" So in the end, he puts himself into the role that he desires so much, even though it's completely insane to do so.
Rationally, even for an unbalanced individual, it might make more sense to do what the story seems to lead you to believe, that the mentor will become the new Toy. After all, the mentor had the best of both worlds, being able to take the credit for the work without suffering himself. But I would not accuse this narrator of being rational. Besides being completely insane, he is also an idealist in an odd sort of way: He doesn't want to be SEEN as being the best (as many would be satisfied with), he wants to BE the best.