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WATER RIGHTS MAY QUALIFY FOR TAX DEFERRAL

ARE WATER RIGHTS LIKE-KIND PROPERTY?

Internal Revenue Code (IRC) Section 1031 provides, in part, that no gain or loss is recognized on the exchange of property for other property of a like-kind. In other words, to qualify for income tax deferral under §1031, the property relinquished in the exchange must be sufficiently like the property received in the exchange. Fortunately, most property rights characterized as real property under state law are considered like-kind to other interests that are also considered real property under local law. Thus an easement or mineral right in most cases will be considered like-kind to a fee simple interest in real property and vice versa. If easements and mineral rights are considered like-kind to a fee simple interest in real property, then what about water rights?

In recent years, developers have been willing to purchase water rights at a significant premium and some economists expect the premium to increase in the future. Does a sale of water rights qualify for income tax deferral under Section 1031? In most states, perpetual water rights are recognized as an interest in real property that would qualify as “like-kind” to a fee interest real property. See, e.g. Revenue Ruling 55-749, 1955-2 CB 295; IRS Private Letter Ruling 200404044. On the other hand, water rights that are limited in amount or duration may not be considered sufficiently like a fee interest in real property. In Weichens v. United States, 228 F. Supp. 1080 (Arizona – 2002), for example, the court held that the water rights in question were so limited in priority, quantity, and duration as to not be like-kind to a fee simple interest in real property.

DOES DITCH STOCK QUALIFY FOR SECTION 1031 DEFERRAL?

Like-kind issues also arise where water rights are owned indirectly. In some states, water is allocated among land owners by means of ditches. Ditches may be individually owned or may be “mutual” incorporated ditches. Water in incorporated ditches is allocated by shares issued by the company. The ditch shares represent proportional amounts of water rights held by the ditch company. In most cases, stock certificates are issued by ditch companies. So, can ditch stock be exchanged for real property in a Section 1031 exchange?

Section 1031(a)(2)(B) provides that “stocks, bonds or notes” may not be exchanged in a §1031 exchange. Thus, a taxpayer cannot sell stock in a corporation that owns real property even if the underlying real property would qualify as like kind property. Under this reasoning, it would seem that a sale of ditch stock should not qualify for deferral under §1031. On May 22, 2008, however, Congress enacted the Food, Conservation and Energy Act of 2008 which is often referred to as the Farm Bill. Among other things, the Act amends IRC Section 1031(a)(2)(B) to exclude mutual ditch, reservoir or irrigation company stock from the definition of “stock.” As a result, mutual ditch, reservoir or irrigation company stock should now be eligible in §1031 exchanges. In order to qualify for this treatment, the new law requires that ditch stock must be treated as an interest in real property under the law of the state in which the corporation is located.

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