What happens for tax purposes when the person with a life interest in a spousal trust dies?

When the life-interest beneficiary of a spousal trust dies, typically the surviving spouse for whom the trust was set up, the trust's tax year is deemed to end immediately before that death, and the trust faces a deemed disposition of its capital property at fair market value at that point, generally triggering tax on any accrued gain. This is separate from, and doesn't depend on, where the trust happens to sit on its ordinary 21-year deemed disposition cycle.

The reason the tax deferral ends here is that the spousal trust's rollover benefit was tied specifically to the life-interest beneficiary being alive and entitled to all the trust's income; once they've died, that condition can no longer be met, so the trust is treated much like an individual's own death for this purpose, with its own return required for the resulting short tax year.

If the trust continues afterward for other beneficiaries, it carries on subject to the ordinary trust tax rules, including its own future 21-year rule, from that point forward. Because this creates a filing obligation and a real tax bill that can catch a family off guard right when they're also dealing with a death, the trustees should involve the trust's accountant as soon as the life-interest beneficiary's death occurs.