CE500 instructor pilot reported his student lost 300 FT of altitude during single engine practice and neither pilot being aware until notified by ATC.

Narrative

I was giving a biennial flight review in the private owner's aircraft. He wanted to also do some single engine work. After doing a touch & go; I pulled the #2 engine back to idle on climb out. While getting vectors for a return for the ILS; the owner was working on getting the plane trimmed up. I was offering verbal guidance when the Controller asked us to state our altitude. To my disbelief; we were at 2200 FT. Our assigned altitude was 2500. I stated that we had dropped to 2200 FT and were climbing back up to 2500. The owner was so engrossed in taking care of the aircraft and trimming the rudder and ailerons that he never even watched the altimeter. I was talking to him about things that would help him get the aircraft squared away in a more timely fashion and also was not watching the vertical activity of the aircraft. The controller never mentioned the event again and we continued with our planned single engine ILS then returned to the owner's home base airport. The owner learned to keep his scan in an emergency and I learned that I could have waited a bit on some of what I was trying to help him with; when he could have better absorbed it and allowing him and me to keep better attention to the immediate task at hand.