Families often sell investments such as stocks, bonds and mutual funds
to pay college bills. If these investments are not held within a 529
college savings plan or other qualified tuition plan, however, the
capital gains from selling the investments can hurt the student's
eligibility for need-based financial aid.
Capital gains occur when you sell an asset that has appreciated in
value. The gain is the difference between the selling price and purchase
price. Capital gains are reported as income on
IRS Form 1040
and as such are included in adjusted gross income.
Impact on Aid eligibility
This can affect eligibility for need-based financial aid in two
ways:
1. The Free Application for Federal Student Aid (FAFSA) bases total
income on the sum of the taxpayer's adjusted gross income with untaxed
income and benefits for the preceding tax year minus certain types of
excludable income such as student aid and child support payments. Thus
capital gains can artificially inflate income. Since the need analysis
formula is heavily weighted toward total income, an increase in income
can increase the expected family contribution (EFC) and reduce
eligibility for need-based financial aid.
The preceding tax year is known as the base year. If a high school
senior files the FAFSA for the 2011-12 award year (say, on January 1, 2011),
the base year is 2010. Capital gains realized in 2010 will affect the
EFC on this FAFSA.
2. The federal need analysis methodology includes two simplified
formulas, the simplified needs test and auto-zero-EFC. The student's
parents must satisfy certain income thresholds to qualify for these
simplified formulas. In addition, the parents must be eligible to file
an IRS Form 1040A or 1040EZ or they must have received benefits from a
means-tested federal benefit program (e.g., SSI, Food Stamps, TANF,
WIC or the Free and Reduced Price School Lunch programs). Taxpayers
with capital gains or losses are required to file an IRS Form
1040. Although they could still qualify by receiving benefits from a
means-tested federal benefit program, a family with capital gains is
much less likely to qualify.
Workarounds
There are two practical solutions to this problem. One solution is to
realize any capital gains at least two tax years prior to filing the
FAFSA. For example, the parents of a college-bound child should
realize any capital gains no later than the fall of the child's junior
year in high school, before the start of the base year. The other
solution is to balance capital gains with losses in order to avoid
artificially inflating income.
There is also an exception when capital gains are realized as the result of
"a sale of farm or business assets of a family if such sale results
from a voluntary or involuntary foreclosure, forfeiture, or bankruptcy
or an involuntary liquidation." Section 479A(b)(1) of the Higher
Education Act of 1965 gives college financial aid administrators the
authority to exclude the proceeds of such a sale from income. However,
college financial aid administrators are unlikely to grant an
adjustment to income for capital gains in other situations.
