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A federal appeals court has ruled against the IRS in its treatment of a sale of a property's water rights.
In 1976, the Gladdens ("Owners") purchased a 50% partnership interest in 880 acres of farmland for $675,000 in Arizona. At the time of the purchase, the property had no water appurtenant rights ("Water Rights"), but the property was part of an irrigation district ("District") which had been formed to obtain water rights for the District, pursuant to a 1968 Congressional act which authorized the bringing of water to an area of central Arizona which included the District. In 1983, the District obtained the right to distribute Colorado river water to members of the District like the Owners. While the Owners were not permitted to sell these rights during the first ten years of ownership, in 1993 the federal government allowed members of the District to sell their water rights. The Owners, in conjunction with the partnership, took advantage of this opportunity and sold the Water Rights. The Owners' share of the sale was $543,566. In their 1993 federal tax returns, the Owners listed the sale of the Water Rights as a capital gain and deducted this amount from the property's tax basis, reporting a taxable gain of $130,762.
The Internal Revenue Service ("IRS") objected to the Owners' method of calculation, stating that the entire sale amount of the Water Rights was ordinary income and this should not be offset against the property's tax basis because the Owner only had an expectancy in the Water Rights at the time of purchase. Thus, the IRS issued a deficiency tax bill to the Owners. The Owners appealed to the tax court ("Tax Court"), and the Tax Court ruled that the Water Rights were a capital asset and that the Water Rights had been "sold" within the meaning of the federal tax code. However, the Tax Court ruled that the Owners could not apply their tax basis to the sale, since the Water Rights were not acquired by the Owners until after they had purchased an interest in the property. The Owners appealed.
The United States Court of Appeals, Ninth Circuit, reversed the Tax Court and sent the case back to the Tax Court for further proceedings. The court first considered if a portion of the purchase price the Owners paid in 1976 could be allocated as a cost basis for the Water Shares, which was an expected right in 1976 although not vested at that time. The court found there were two possible ways to treat the Water Rights. Looking at a federal regulation promulgated by the IRS, the court found that the Water Rights could be treated like a property when it is divided into parcels for sale: equitably allocating the property's original sale price between all of the parts of the entire property, in order to create a tax basis for each parcel sold. Another way to treat the Water Rights would be if there had no been no expectation by the Owners in receiving the Water Rights at the time of the purchase, which would mean that the Owners would not have a basis in the Water Rights.
While the court stated that although the Water Rights did not fit clearly into either of the possible methods for treating the Water Rights, the court rejected the Tax Court's rulings and ruled that the Water Rights had a tax basis, since the Owners had a legitimate expectancy of water rights when they purchased an interest in the property. The court analogized this case to a case involving pregnant cows. In that case, the court found that the cows were worth substantially more when pregnant, and the difference between what the cows were worth when pregnant and after they gave birth was the basis that the farmer took in the calves. The court found that the expectation of calves at the time the pregnant cows were purchased was similar to the Owners' expectation of water rights when they purchased an interest in the property, and so the court ruled that the Owners could claim a basis in the Water Rights.
The court next considered what the proper basis amount should be for the Water Rights. The Owners argued that since it was "impossible or impractical" to determine the amount paid for the expectancy of Water Rights, the Owners were not required to recognize any capital gain until their entire cost basis for the property had been recovered. The court rejected this argument, ruling that there might be a way to determine the cost basis for the Water Rights by looking at sale prices for similar properties, with the Water Rights basis then being the difference between the Owners' purchase price and the prices of the other properties. Therefore, the court remanded the case back to the Tax Court for further proceedings to determine what additional amount was paid by the Owners for the Water Rights. Thus, the Tax Court's rulings were reversed and the case was sent back to the Tax Court.
Gladden v. Commissioner, 262 F.3d 851 (9th Cir. 2001).
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