IRS deems certain water rights “real property” under Section 1031


The IRS recently released guidance (PLR 202309007) concluding that certain water rights are "real property" and are “like-kind” to a fee simple interest in real property for purposes of Section 1031, as long as all properties are held for productive use in a trade or business or for investment.


Section 1031(a) generally provides that no gain or loss is recognized on the exchange of like-kind real property held for productive use in a trade or business or for investment.


The taxpayer addressed by the PLR held a license for the unrestricted diversion and use of water in perpetuity with other ranch owners who were the successors in interest to the same water rights. The taxpayer and the other ranch owners operated separate farming and cattle operations, did not carry on a joint business activity, and never joined in filing a partnership return with respect to their ownership of their respective properties. The taxpayer and other ranch owners had an agreement that if all or a portion of the water rights were sold, the proceeds would be allocated amongst them.


The taxpayer planned to sell a portion of the water rights and to reinvest the proceeds in real property and wanted to treat the transaction as a nonrecognition event under Section 1031.


Under state law procedures, the license would be bifurcated into two separate licenses: the first vested in the taxpayer and the second vested in the buyer for the portion of rights that were sold. The cash sales proceeds would be allocated among the taxpayer and other ranch owners pursuant to their agreement.


The IRS looked to Rev. Rul. 55-749, where the IRS concluded that the water rights and the land involved were sufficiently similar to constitute “property of a like-kind” within the meaning of Section 1031, because the water rights were granted "in perpetuity" and were not merely rights “to a specific total amount of water or to a specific amount of water for a limited period."


The IRS contrasted this analysis with the case Wiechens v. United States, in which the U.S. District Court for the District of Arizona found that because a taxpayer’s water rights were narrowly restricted in priority, quantity and duration, the water rights were not sufficiently similar to the fee simple interest that it acquired in farmland to qualify as like-kind property — even though the taxpayer’s water rights constituted an interest in real property.


In PLR 202309007, the IRS determined the pertinent water rights were real property that is like-kind to a fee interest in real property because the water rights were:


  • Real property under state law
  • Sold under a license granting the ranch owners rights to a set volume of water each year
  • Perpetual
  • Subject only to the right of a state to terminate based on a finding that they are not being put to beneficial use


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