When is Real Estate Reported as a Business Asset on the FAFSA?

<b>For parents who are self-employed and own real estate as one of their businesses, should they list the real estate assets as their assets (since they are self-employed) or as business assets? Does it make a difference one way or other? When we listed $350,000 in property as our assets, it made a huge difference but we are not sure how to differentiate something between our own asset versus a business asset (if self-employed). — S.S. There are two ways in which real estate can be reported as an asset on the Free Application for Federal Student Aid (FAFSA): investment real estate and business/farm assets. The family's principal place of residence and a family farm that is the family's principal place of residence are not reported as assets on the FAFSA. But other real estate may be reported as an asset on the FAFSA. The question often arises as to whether a rental property is an investment asset or a business/farm asset. In most cases rental property should be reported as an investment asset. For real estate to be considered a business asset, it must be used in the operation of the business, not incidental to it. Subregulatory guidance published by the US Department of Education indicates that "A rental property would have to be part of a formally recognized business to be reported as such, and it usually would provide additional services like regular cleaning, linen, or maid service." This is similar to IRS guidance concerning whether rental income from real estate must be reported on Schedule E or Schedule C of IRS Form 1040. According to IRS Publication 527, in order to report the rental income on Schedule C, the taxpayer must "provide significant services that are primarily for your tenant's convenience, such as regular cleaning, changing linen, or maid service" and "significant services do not include the furnishing of heat and light, cleaning of public areas, trash collection, etc." It isn't always clear whether rental real estate should be reported as a business asset or as an investment asset, but there are a few good rules of thumb.

• If the rental income is reported on Schedule E, the real estate should be reported as an investment asset.
• If the rental income is commingled with the taxpayer's personal funds as opposed to a separate business bank account, the real estate should be reported as an investment asset.
• If the deed or title to the real estate is held by the business, as opposed to the taxpayer, it should be reported as a business asset. But if the business merely manages the real estate without owning the real estate, the real estate is not a business asset.
• If the business is not registered with the state and does not have a federal employer identification number (EIN), the real estate should probably be reported as an investment asset.
• If the primary use of the real estate is personal, such as a vacation home, it should be reported as an investment asset.
• Renting out a room in the family home (to someone other than a family member) does not count as a business asset, unless it has its own entrance, kitchen and bath.

Impact of Business Assets on Financial Aid

Families prefer to report real estate as a business or farm asset because these assets have less of an impact on the student's expected family contribution (EFC) than investment assets. Certain types of business assets are excluded from the FAFSA, and reportable business assets are adjusted to protect part of the net worth from need analysis. The small business exclusion allows the applicant to omit the net worth of a small business from the FAFSA. A small business has 100 full-time or full-time equivalent employees and is owned and controlled by the family. More than 50% of the business must be owned by people who are directly related by birth or marriage. (The family members who own the business do not have to all be counted in the household size on the FAFSA to qualify for the small business exclusion.) If real estate is reported as a business asset on the FAFSA, the federal need analysis formula partially shelters the net worth of the asset by reducing its value according to a bracketed scale. The first several hundred thousand dollars of the net worth is reduced by 40 to 60 percent. The net worth of a business is calculated by subtracting any debt secured by the business from the current market value of the business. If the business was not used as collateral on the loan, the debt is not subtracted from the value of the business. For example, if family used a home equity loan on their home to fund the business, the debt is not subtracted from the value of the business because the loan is secured by the family home and not the business. Similarly, credit card debt on a personal credit card does not reduce the net worth of the business.