Section 107(2) of the Income Tax Act: Rollover and T3 Reporting

Section 107(2) of the Income Tax Act lets a personal trust hand capital property to a Canadian-resident beneficiary without triggering an immediate tax bill on either side. The trust is treated as having disposed of the property for its cost amount, the beneficiary picks up that same cost amount as their acquisition price, and the accrued gain stays embedded in the property until the beneficiary eventually sells. The rollover is automatic when the conditions are met. It fails, sometimes expensively, when they are not.

What Happens on the Distribution

Three things occur at once under subsection 107(2). The trust is deemed to dispose of the property for proceeds equal to its cost amount immediately before the distribution. The beneficiary is deemed to acquire the property at that same cost amount, adjusted upward if the adjusted cost base of the beneficiary’s capital interest exceeds its cost amount. And the beneficiary’s proceeds for the capital interest given up in exchange are computed by formula using the cost of the property received and any eligible offsets.¹

The practical result is clean. No capital gain or loss is recognized by the trust. The beneficiary inherits whatever unrealized gain or loss the trust was carrying. Shares the trust bought for $50,000 that are now worth $120,000 leave the trust with a $50,000 cost base in the beneficiary’s hands. The $70,000 gain remains unrealized until the beneficiary sells. Tax is deferred, not erased.

Which Trusts and Which Distributions Qualify

The rollover is available only when the distributing trust is a personal trust or a prescribed trust. A personal trust, as defined in subsection 248(1), is either a graduated rate estate or a trust in which no beneficial interest was acquired for consideration paid to the trust or to a contributor of property to it.² Most family trusts fit the definition, whether created during the settlor’s lifetime or by will, provided no one paid to become a beneficiary. Unit trusts, mutual fund trusts, and other commercial arrangements where beneficiaries buy their interests are outside this definition and cannot use 107(2).

The distribution also has to satisfy all or part of a beneficiary’s capital interest, not an income interest. Under subsection 108(1), a capital interest is all rights of a beneficiary other than an income interest, and an income interest is the right to receive the trust’s annual accounting income.³ Distributions of trust income to beneficiaries flow through under separate rules, mainly subsection 104(6). If a trustee moves property out but the movement does not reduce the beneficiary’s capital interest, 107(2) does not apply. Trustees need the trust deed to clearly authorize capital distributions before relying on the rollover.

Depreciable Property

When the property is depreciable, paragraph 107(2)(d) layers on extra rules. The beneficiary is deemed to acquire the property at the trust’s original capital cost rather than the reduced undepreciated capital cost, and the difference is treated as depreciation the beneficiary has already claimed.¹ The beneficiary picks up where the trust left off; the depreciation clock does not reset.

When the Rollover Is Denied

Non-Resident Beneficiaries

The deferral does not apply when the beneficiary is not a Canadian resident. Subsection 107(5) directs that subsection 107(2.1) applies instead, so the trust is deemed to dispose of the property at fair market value.¹ Any accrued gain is realized immediately in the trust, and the non-resident beneficiary takes the property with a cost base equal to fair market value. The policy is that appreciated assets should not leave the Canadian tax base without the accumulated gain being taxed.

A narrow exception preserves the rollover for certain Canadian-situated property described in subparagraphs 128.1(4)(b)(i) through (iii), generally Canadian real property, Canadian resource property, and timber resource property, because Canada retains taxing rights over the eventual sale regardless of the owner’s residence.

The 75(2) Attribution Trap

The most dangerous denial in trust planning comes from the interaction between subsection 75(2) and subsection 107(4.1). Subsection 75(2) attributes trust income and capital gains back to a contributor when the property is or was held on terms letting the contributor get the property back, direct who receives it, or veto its disposition.⁴

Under subsection 107(4.1), if 75(2) applied at any point to any property of the trust, the 107(2) rollover is denied for distributions to anyone other than the original contributor or their spouse or common-law partner. The denial holds even if the 75(2) issue was temporary, has been fixed, or affected only a small portion of the trust’s assets.¹ The distribution then falls under 107(2.1), so the trust disposes of the property at fair market value with the accompanying gains, recapture, and other inclusions.

Poorly drafted trust deeds are the usual culprit. If the deed gives the settlor any power to redirect assets or requires the settlor’s consent for dispositions, 75(2) is triggered and the rollover is lost for every beneficiary except the settlor and their spouse. Reviewing the deed before any distribution is not optional.

Using 107(2) to Beat the 21-Year Deemed Disposition

Every trust in Canada faces a deemed disposition of its capital property at fair market value on its 21st anniversary and every 21 years after that. Subsection 104(4) treats the trust as having sold and immediately reacquired each capital property (other than depreciable property and certain exempt property) at fair market value, forcing recognition of all accrued gains.⁵ Trusts holding illiquid assets like real estate or private company shares can face a large tax bill with no cash to pay it.

This is where 107(2) earns its planning value. Distributing property to Canadian-resident beneficiaries on a tax-deferred basis before the 21-year anniversary lets the trust avoid the forced deemed disposition. The beneficiaries take the property with the trust’s cost base and can deal with the gain on their own timelines. If the trust deed does not authorize capital distributions, legal advice on whether the terms can be amended should be sought well before the anniversary. Waiting until the last minute is how trusts end up paying tax on gains for assets they never actually sold.

The Principal Residence Election Under 107(2.01)

Subsection 107(2.01) offers a narrow but valuable election. When the trust distributes property that could qualify as its principal residence, it can elect in its return for the year of distribution to be treated as having disposed of the property at fair market value immediately before the distribution, and then reacquired it at that value before 107(2) takes effect.¹

The point is to let the trust use the principal residence exemption to shelter the gain that accrued while it held the home. Without the election, 107(2) transfers the property at cost, embedding the gain, and the exemption is never claimed on that appreciation. The election crystallizes the gain at the trust level, shelters it, and hands the beneficiary a stepped-up cost base. It applies only to property that qualifies as a principal residence and must be made in the trust’s return for the year of distribution.

The 2026 Inclusion Rate Change

Starting January 1, 2026, the federal government has announced that the capital gains inclusion rate will increase from one-half to two-thirds for corporations and most trusts on all capital gains realized, and for individuals on annual capital gains exceeding $250,000.⁶ The change matters for 107(2) planning. If the rollover is unavailable and a gain is triggered inside the trust (through a non-resident beneficiary, an attribution problem, or the 21-year rule), the trust generally faces the two-thirds rate on the entire gain with no $250,000 threshold. If the property is rolled out to a Canadian-resident individual under 107(2) and the individual later sells, the individual gets the $250,000 annual threshold before the higher rate kicks in. Timing a distribution around this change can shift real tax liability.

Reporting the Distribution on the T3

Every 107(2) distribution is reported on the T3 Trust Income Tax and Information Return.⁷ Schedule 9 shows what the trust allocated or distributed and to whom.⁸ If the 107(2.01) principal residence election is made, it must be indicated in the return for the year of distribution.

The T3 is due 90 days after the trust’s tax year-end, or 90 days after the date of the final distribution if the trust ceases to exist.⁹ Beneficiaries must also receive a T3 slip summarizing any income allocated or designated to them.

Late Filing Penalties

Penalties for a late T3 depend on whether there is unpaid tax:

With unpaid tax, the penalty is 5% of the unpaid tax at the filing deadline plus 1% of that amount for each full month the return is late, to a maximum of 12 months. If the CRA has already assessed a late-filing penalty for any of the three preceding years and issued a demand to file, the penalty jumps to 10% plus 2% per month, up to 20 months.
With no unpaid tax, an alternative penalty of $25 per day applies, minimum $100, maximum $2,500.
For false statements or omissions, on trusts that are not listed trusts, the penalty is the greater of $2,500 or 5% of the highest total fair market value of all trust property at any time during the year. A further penalty equal to the greater of $100 or 50% of the understated tax may also apply.

Accuracy is worth the effort.⁷

Late Election Relief

If the 107(2.01) election or another election related to the distribution is missed, subsection 220(3.2) gives the Minister of National Revenue authority to accept late-filed elections or to allow amendments or revocations of elections already made. A penalty may apply for a late election, and the request must include supporting facts and documentation explaining the delay. The CRA reviews each request on its own circumstances.¹⁰

1
Justice Laws Website. Income Tax Act – Section 107
2
Justice Laws Website. Income Tax Act – Section 248
3
Canada Revenue Agency. Income Tax Folio S6-F2-C1, Disposition of an Income Interest in a Trust
4
Justice Laws Website. Income Tax Act – Section 75
5
Justice Laws Website. Income Tax Act – Section 104
6
Canada Revenue Agency. Government of Canada Announces Deferral in Implementation of Change to Capital Gains Inclusion Rate
7
Canada Revenue Agency. T3 Trust Guide – 2025
8
Canada Revenue Agency. T3SCH9 Income Allocations and Designations to Beneficiaries
9
Canada Revenue Agency. Filing and Payment Due Dates
10
Canada Revenue Agency. Taxpayer Relief Provisions