Section 107 Rollovers: Tax-Deferred Property Transfers from Trust

Section 107 of the Income Tax Act is a crucial provision for trustees managing personal trusts, especially in family-owned enterprises. It allows for tax-deferred rollovers of capital property from a trust to its beneficiaries. This means that capital assets such as real estate, shares, or other investments can be transferred without immediately triggering capital gains tax. However, the availability of this tax-free rollover depends on the type of trust, the nature of the property being transferred, and the specific circumstances under which the transfer is made. The tax-deferred nature of Section 107 rollovers can be highly beneficial in maintaining wealth within the family and ensuring that trusts are managed efficiently without facing large tax liabilities upon the transfer of assets.

This step-by-step guide provides an in-depth explanation of how Section 107 works, along with important considerations for achieving the tax-free rollover and preserving the trust’s assets.

1. Understand the Type of Trust Involved

The first critical step in achieving a tax-free rollover under Section 107 is determining whether the trust qualifies. Section 107 primarily applies to personal trusts, which fall into two main categories:

• Testamentary Trusts: These are trusts created through a will, typically upon the death of the settlor. Testamentary trusts are often used for estate planning purposes to provide for the financial well-being of heirs.
• Inter Vivos Trusts: These trusts are established by the settlor during their lifetime. Inter vivos trusts are often used for asset protection, tax planning, and ensuring the smooth transfer of family wealth across generations.

While Section 107 provides rollovers for personal trusts, it does not apply to commercial trusts or unit trusts, where beneficiaries purchase their interest in the trust. For example, in unit trusts—where beneficiaries acquire units like shares in a mutual fund—the tax deferral provision is generally not available.

Eligibility Criteria for Section 107:

• The trust must be considered a personal trust, and beneficiaries must have acquired their interest either through inheritance, gifts, or family relationships, rather than through purchase.
• The trust must hold capital property that can be rolled over to beneficiaries without triggering an immediate tax event.

Failure to meet these requirements means that the trust may be subject to normal tax rules upon transferring assets, including capital gains tax at the time of transfer.

2. Identify the Capital Property for Transfer

Once it is established that the trust qualifies under Section 107, the next step is to identify the capital property eligible for the tax-deferred rollover. Capital property typically includes:

• Real Estate: Residential or commercial properties held by the trust for investment purposes.
• Shares in a Family Business: Shares of a family-owned enterprise held in the trust for estate planning purposes.
• Investments: Bonds, mutual funds, or other investment portfolios held by the trust.

It is important to note that Section 107 applies specifically to capital property, not income-producing property or personal-use property. For example, income-producing assets such as rental properties or personal-use properties like a primary residence may not benefit from the same tax treatment under Section 107.

For trusts holding significant assets in a family-owned business, the tax-deferred transfer of shares can provide substantial benefits, as it allows the assets to remain within the family without facing immediate tax consequences. This deferral preserves the capital for future growth, which can be crucial for long-term family wealth management.

3. Determine the Beneficiary’s Capital Interest

The next step in executing a Section 107 rollover is confirming the beneficiary’s entitlement to capital within the trust. Section 107 rollovers are only available when the beneficiary has a capital interest in the trust’s assets, rather than just an entitlement to trust income.

For example, if a trust is structured to provide income distributions to beneficiaries (such as dividends or rental income), these income beneficiaries may not have a direct capital interest. In such cases, a tax-free rollover would not apply. However, beneficiaries with a capital interest in the trust—such as those who will inherit the underlying property or assets—are eligible for the Section 107 rollover.

Capital vs. Income Beneficiaries:

• Capital Beneficiaries: Entitled to the actual property or assets of the trust upon distribution or termination.
• Income Beneficiaries: Entitled only to the income generated by the trust assets, without rights to the underlying property.

Ensuring that beneficiaries have a capital interest is critical for applying the rollover. In family-owned enterprises, capital beneficiaries are often direct descendants who stand to inherit shares or other property directly from the trust.

4. Execute the Tax-Deferred Transfer of Capital Property

Once eligibility and property types have been determined, the trustee can proceed with the tax-deferred transfer of capital property under Section 107. The transfer occurs at the property’s adjusted cost base (ACB), meaning that no immediate capital gains are recognized.

Here’s how it works:

• The property is transferred to the beneficiary at its original purchase price (the ACB), rather than its fair market value (FMV) at the time of transfer.
• For example, if a trust purchased real estate for $300,000, and the current market value is $700,000, the property is transferred at the ACB of $300,000. The capital gains of $400,000 are deferred until the beneficiary eventually sells the property.

This step is crucial in maintaining the tax efficiency of the trust, as it avoids the immediate tax liability that would arise if the property were deemed to be disposed of at FMV.

5. Understand the Beneficiary’s Tax Obligations Upon Sale

After the rollover, the beneficiary assumes the adjusted cost base of the property. This means that when the beneficiary eventually sells the property, they will be responsible for capital gains tax based on the difference between the ACB and the sale price.

Using the previous example of real estate, if the beneficiary later sells the property for $900,000, their capital gain will be calculated as $900,000 (sale price) minus $300,000 (ACB), resulting in a capital gain of $600,000. At that point, the beneficiary will be responsible for paying the capital gains tax.

This deferred tax obligation allows beneficiaries to control the timing of the tax event, giving them flexibility to plan for the eventual sale of the property.

6. Filing and Compliance with CRA Requirements

Proper compliance with CRA regulations is essential to ensure the successful application of Section 107. The trust must report the transfer of capital property, even though no capital gains are recognized at the time of transfer. This requires the trustee to provide:

• Accurate documentation of the transfer, including the property’s ACB and FMV at the time of transfer.
• A clear reporting structure that details the transfer and the deferred capital gains liability assumed by the beneficiary.

Additionally, the trust must ensure that all tax filings are up to date, including any final returns filed upon the trust’s termination or substantial variation.

7. Strategies for Optimizing Section 107 Rollovers

To maximize the benefits of Section 107 rollovers, families and trustees can implement several strategies:

• Consider Staggered Transfers: Instead of transferring all capital property at once, trustees may stagger the transfer over time to allow for better tax management for beneficiaries.
• Use Lifetime Capital Gains Exemption (LCGE): Beneficiaries may also be able to apply the Lifetime Capital Gains Exemption to reduce their tax liability when they eventually sell capital property such as shares in a qualifying family-owned business.
• Plan for Long-Term Deferral: By keeping capital property in the trust for longer periods, trustees can manage tax deferrals more effectively, allowing beneficiaries to inherit property under more favorable tax conditions.

Conclusion

The Section 107 rollover provisions in the Income Tax Act provide an invaluable tool for preserving wealth within family-owned enterprises. By allowing capital property to be transferred from a trust to beneficiaries without triggering immediate capital gains, this provision ensures that families can manage their wealth effectively while deferring tax liabilities until a later date. However, careful planning is required to ensure compliance with the rules and to maximize the tax deferral benefits. Proper trust structure, accurate identification of capital property, and strategic tax planning are key elements in successfully achieving tax-free rollovers under Section 107, ensuring that family wealth is protected across generations.

This information is for discussion purposes only and should not be considered professional advice. There is no guarantee or warrant of information on this site and it should be noted that rules and laws change regularly. You should consult a professional before considering implementing or taking any action based on information on this site. Call our team for a consultation before taking any action. ©2024 Shajani CPA.

Shajani CPA is a CPA Calgary, Edmonton and Red Deer firm and provides Accountant, Bookkeeping, Tax Advice and Tax Planning service.

Trusts – Estate Planning – Tax Advisory – Tax Law – T2200 – T5108 – Audit Shield – Corporate Tax – Personal Tax – CRA – CPA Alberta – Russell Bedford – Income Tax – Family Owned Business – Alberta Business – Expenses – Audits – Reviews – Compilations – Mergers – Acquisitions – Cash Flow Management – QuickBooks – Ai Accounting – Automation – Startups – Litigation Support – International Tax – US Tax – Business Succession Planning – Business Purchase – Sale of Business