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.
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.