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what do i do with the $7,000 on the 1041 i am filing for the trust?

Ignore it.

is it income to the trust and a distribution to my sister?

No and no.

if not, what is it?

It's a reimbursement for an insured loss. You wouldn't pay income tax on that if it were on your personal return. You wouldn't report anything about it on your personal return. Neither would you do anything on the trust's return.

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