"It seems you are describing a strange situation when your BIL family was cheating on taxes but suddenly decided to be honest on FAFSA. It is either one household or two households irrespectively of the number of houses. "
No, they weren’t married when they filed HOH. They each had a home, they each paid all the expenses for the home each claimed as a main residence (hers in town, his about 70 miles away), they split the expenses for their two children. Not really different than divorced parents each claiming one child as the dependent even though both kids are always living in the same household together; my brother does this with his twins - he claims one, ex claims one, both are HOH, kids are always together but there are two households. Once BIL/sister got married, they started filing as married but each still resided in a different house, the house closest to work and that each owned before the marriage. Now, many years later, they just have an atypical living arrangement and accept that as an outlier to FAFSA, and put both houses on the FAFSA where they are penalized as if they own a vacation home and a residence. I have other married friends who do it too, and the H declares the other house as a primary residence. He has cars registered at the second house, votes from there, served jury duty from that address. It is because they invested an inheritance in that house and need to hold it for 5 years to avoid capital gain. Not illegal, just tax planning. If they had FAFSA aged kids (they don’t), they’d fill the forms out correctly, claiming two residences (with no rental income, that’s the price of getting out of the capital gains tax, and they think it is worth it to avoid the cap. gain).
FAFSA and the other forms are set up to cover the more common arrangements - married, divorced, remarried, etc. Now it is becoming more common for two parents to live together but never married (Goldie Hawn and Kurt Russell), so the 2014 forms started including that status. Most people who are able to have two separate households are usually professionals who won’t qualify for a lot of FA anyway (my sister changed careers, so current income is a lot less than it was when she bought her house), so it doesn’t make much of a difference and probably not worth the legislative time to establish yet another household type.
OP’s situation is a Goldie/Kurt one, so under the new FAFSA rules she now must list the income for both bio parents she lives with and, since verification was required, provide both tax transcripts. Two years ago this wouldn’t have been a problem because she only would have had to report one parent as the custodial parent, not married. If this was her mother and her mother’s boyfriend, no problem you just leave the boyfriend out of it (even if he claimed HOH if the younger sibling was his child), but since it’s two bio parents, FAFSA now requires both tax transcripts.