112 T.C. No. 15
UNITED STATES TAX COURT
WILLIAM T. GLADDEN AND NICOLE L. GLADDEN, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 16932-97. Filed April 15, 1999.
On cross-motions for partial summary judgment, held, partnership water rights constitute capital assets. Held, further, no portion of partnership's tax basis in land the partnership acquired in 1976 is to be allocated to the water rights the partnership acquired in 1983 and relinquished in 1992.
William Louis Raby, Burgess J. William Raby, and
James J. Rossie, Jr., for petitioners.
Katherine Holmes Ankeny, for respondent.
OPINION
SWIFT, Judge: This matter is before us on the parties'
motions and cross-motions for partial summary judgment. - 2 -
In 1993, as investors in a partnership named Saddle Mountain
Ranch which owned land in Harquahala Valley, Arizona (the
partnership), petitioners received a portion of $28.7 million
paid by the Federal Government to certain Harquahala Valley
landowners in connection with the landowners' relinquishment of
the right each year to receive Colorado River water to irrigate
their land (water rights).
Initially, the parties cross-move for partial summary
judgment on the issue as to whether the partnership’s water
rights constitute capital assets. Respondent would treat the
partnership's water rights as not rising to the level of capital
assets.
If, as a matter of partial summary judgment, we conclude
that petitioners' water rights do constitute capital assets, then
the parties cross-move for partial summary judgment on the issue
as to whether the funds should be regarded as having been
received in a sale or exchange for the water rights so as to
qualify the funds received as capital gain income.
If each of the above issues is resolved in favor of
petitioners, the parties cross-move for partial summary judgment
on the issue as to whether any of the partnership's approximate
$675,000 tax basis in its ownership interest in Harquahala Valley
land is allocable to and would offset funds received for the
water rights.
petitioners, petitioners then move for partial summary judgment - 3 -
on the issue as to how much of the partnership's tax basis in the
land is allocable to the water rights. Petitioners contend that
it would be impossible to allocate any specific portion of the
partnership's tax basis in the land to the partnership's water
rights, and petitioners therefore contend that the partnership's
total tax basis of approximately $675,000 in the land should be
allocated to the water rights and should offset the funds the
partnership received. Respondent objects to partial summary
judgment on this issue on the grounds that material facts remain
in dispute as to what portion of the partnership's tax basis in
the land should be allocated to the water rights.
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the year in issue.
Set forth below are the facts relating to the above issues.
When the petition was filed, petitioners resided in Buckeye,
Arizona.
In 1928, the Boulder Canyon Project Act, ch. 42, 45 Stat.
1057 (1928), was enacted. This statute relates to use and
allocation of lower Colorado River water and is the statute under
which the water rights at issue in this case were granted.
In 1963, the Supreme Court decided Arizona v. California,
373 U.S. 546 (1963), and concluded therein, among other things,
that the Boulder Canyon Project Act preempted State
administration of lower Colorado River water and that under the
Boulder Canyon Project Act and administrative rulings of the U.S. - 4 -
Department of the Interior (Interior Department), Arizona, each
year, had claim to 2.8 million acre-feet of Colorado River water.
In 1964, under Ariz. Rev. Stat. Ann. sec. 48-2901 (West
1997), the Harquahala Valley Irrigation District (HID) was formed
as an Arizona municipal corporation or political subdivision, and
not as a taxable corporation, for the purpose of establishing a
local water distribution system in and about Harquahala Valley,
Arizona. With regard specifically to water irrigation districts,
under Ariz. Rev. Stat. Ann. sec. 48-2978 (West 1997), it is
provided, among other things, that irrigation districts may
purchase or acquire water rights, construct, acquire, and
purchase canals, ditches, and reservoirs, and distribute water
for irrigation purposes.
In 1968, pursuant to the Boulder Canyon Project Act and
apparently as a followup to the Supreme Court’s decision in
Arizona v. California, supra, the Colorado River Basin Project
Act (CRBPA), Pub. L. 90-537, 82 Stat. 885 (1968), was enacted,
which authorized construction by the Federal Government of the
Central Arizona Project (CAP), a system of aqueducts and related
facilities for distribution of lower Colorado River water
throughout Central Arizona. Under this statute, Colorado River
water that would become available for irrigation of land in
Arizona through the CAP distribution system generally was to be
made available only to land that had a “recent irrigation
history”. CRBPA sec. 304, 82 Stat. 891. - 5 -
In 1971, under Arizona State law, the Central Arizona Water
Conservation District (CAP Water District) was formed as a
special water conservation district responsible for operation and
maintenance of CAP and for repayment to the Interior Department
of construction costs that the Federal Government would incur for
construction of the CAP water distribution system.
In 1976, petitioners and other investors formed the Saddle
Mountain Ranch partnership (the partnership), and for a cost of
approximately $675,000, the partnership acquired an ownership
interest in farmland in Harquahala Valley, Maricopa County,
On February 10, 1983, the Interior Department allocated to
Indian communities, to municipalities and industrial users, and
to non-Indian agricultural users including irrigation districts
such as HID, rights each year to receive, through the CAP
distribution system, up to a specified quantity of Colorado River
water. Notice of Final Decision, 48 Fed. Reg. 12446 (Mar. 24,
1983). Under this allocation, HID was granted the right to
obtain Colorado River water for redistribution to Harquahala
Valley landowners for the purpose of irrigating farmland located
within geographic boundaries of the HID water district.
As set forth in the following schedule, the specific
quantity of lower Colorado River water to which HID was entitled
for the above purpose was 7.67 percent of non-Indian agricultural
lower Colorado River water that was available each year: - 6 -
Annual Allocation (in Acre-feet) of Available CAP Water
Percentage of Non-Indian To To Municipal and To Non-Indian Agricultural Use Indian Use Industrial Use Agricultural Use Allocated to HID
309,828 640,000 Balance 7.67
On November 18, 1983, a water service subcontract relating
to distribution of Colorado River water was entered into between
the Interior Department and the CAP Water District, on the one
hand, and HID, on the other hand (the Subcontract). The
Harquahala Valley landowners were not parties to the Subcontract.
The Subcontract provides for the delivery over the course of 50
years by the CAP Water District to HID of the designated quantity
of available Colorado River water.
Although Harquahala Valley landowners were not named parties
to the Subcontract, the terms of the Subcontract were subject to
approval by Harquahala Valley landowners, and only owners of the
specified 33,251 acres of "eligible land" referred to in the
Subcontract were entitled to receive an allocation of Colorado
River water from HID. The partnership’s land qualified as part
of the eligible acres, and thus under the Subcontract, the
partnership was entitled to receive each year from HID a
specified quantity of available Colorado River water.
Under the Subcontract and Arizona law, each year the
available Colorado River water that was allocated through the CAP
Water District to HID and that HID elected to receive from the - 7 -
CAP Water District was required to be distributed by HID to the
Harquahala Valley landowners on a per-acre basis. See Ariz. Rev.
Stat. Ann. sec. 48-2990 (West 1997).
The Subcontract does not state that the water rights of
Harquahala Valley landowners such as the partnership were
appurtenant to the land.
Before the beginning of each year, the CAP Water District
would notify HID of the amount of Colorado River water that,
under the Subcontract, would be available to HID during the
following year, and HID would submit to the CAP Water District a
requested monthly water distribution schedule for the following
year indicating how much of the available Colorado River water it
wished to receive.
Under the Subcontract, HID was required to pay $2 per acre-
foot for Colorado River water it received under the above
allocation and Subcontract. Over the course of the 50-year term
of the Subcontract, the rate of $2 per acre-foot of Colorado
River water received was subject to periodic review and
adjustment.
Also under the Subcontract, HID was obligated to pay its
share of annual operating and maintenance costs of the CAP Water
District distribution system.
As Harquahala Valley landowners entitled to and receiving
Colorado River water from HID, the landowners, including the
partnership herein, were required each year to pay HID for the
Colorado River water they received under the above allocation and - 8 -
Subcontract, at a rate, with certain adjustments, per acre-foot
of water pegged to what HID was required to pay the CAP Water
District.
Each year, HID, with approval of the CAP Water District
could sell or exchange “excess” water (namely, Colorado River
water available under the Subcontract that the Harquahala Valley
landowners did not wish to receive) but only to landowners within
Maricopa, Pinal, and Pima Counties, Arizona. Funds HID realized
on sale of excess water, over and above its costs, could not be
retained by HID but were required to be paid to the CAP Water
District to pay down the debt obligation of HID to the CAP Water
The Harquahala Valley landowners could sell their beneficial
interests in Colorado River water rights to third parties but
only as part of a sale of their ownership interests in the land.
Under the Subcontract, it was provided that all uses of
Colorado River water by water districts and landowners to whom
the water was allocated and distributed had to be consistent with
Federal Government and CAP Water District directives regarding
Colorado River water.
Under the Subcontract, the Interior Department retained the
right to sell to other water districts, to landowners, and to
others Colorado River water that was not distributed to those
with specific allocations under the Subcontract.
In 1984, HID contracted with the Interior Department for
construction of a water distribution system in and about - 9 -
Harquahala Valley, Arizona (local water distribution system),
that would connect with the CAP Colorado River water distribution
system. HID issued $8.4 million in municipal bonds to raise
funds to reimburse the Interior Department for a portion of
construction costs the Interior Department had advanced for
construction of the local water distribution system.
During 1983 through July of 1992, HID and the Harquahala
Valley landowners received annual distributions of Colorado River
water under the Subcontract.
On July 17, 1992, HID sent a written notice to the
Harquahala Valley landowners of a special election regarding
relinquishment of HID’s water rights under the Subcontract. The
notice explained that HID’s proposed relinquishment of water
rights would occur in exchange for payment by the Federal
Government to HID of HID’s debt and bond obligations to the
Federal Government and for the payment of other funds. The
notice further explained that funds HID would have available as a
result of the payment for relinquishment of its water rights,
after expenses and debts, could be distributed to the Harquahala
Valley landowners.
On August 7, 1992, HID and the Federal Government signed an
agreement in principle under which HID agreed to relinquish up to
100 percent of its Colorado River water rights, and the value of
the water rights to be relinquished was agreed to be $1,050 per
acre-foot of water. - 10 -
On August 11, 1992, the Harquahala Valley landowners,
including the partnership, held an election in which they
approved relinquishment by HID of the Colorado River water rights
under the Subcontract.
On December 1, 1992, a final agreement (Master Agreement)
was entered into between the Interior Department and HID for
relinquishment or termination of HID’s water rights under the
Subcontract. Thereunder, HID relinquished to the Interior
Department its rights under the above 1983 water supply
Subcontract to receive over the course of the next 40 or more
years Colorado River water, and the Interior Department agreed to
discharge HID's debt to the Federal Government in relation to the
construction of the local water distribution system and to pay
HID $28.7 million.
The Master Agreement acknowledged that the terms and
conditions under which HID relinquished its Colorado River water
rights were approved by the Harquahala Valley landowners.
The Master Agreement provided that, in entering into the
agreement, HID was acting in its capacity as a municipal
corporation of the State of Arizona and that there existed no
third-party beneficiaries to the Agreement.
Under the July 17, 1992, notice to the landowners and under
the Master Agreement, landowners who did not agree to
relinquishment of their water rights had the option to continue
to receive Colorado River water under the 1983 Subcontract. - 11 -
Thus, if petitioners' partnership or if any of the other
Harquahala Valley landowners had not agreed to relinquishment of
the water rights, HID could not have disposed of the water rights
relating to the land of the objecting landowners.
Apparently, one Harquahala Valley landowner voted against
relinquishment of the water rights, but the record does not
disclose the subsequent history of that landowner and its receipt
of Colorado River water.
In late 1992, in exchange for relinquishment of its Colorado
River water rights, HID received $28.7 million from the Interior
Department.
On January 5, 1993, HID's board of directors met and
authorized distribution of $24.6 million to the Harquahala Valley
landowners who had approved relinquishment of the water rights.
As part of the distribution that occurred, petitioners'
partnership received $1,088,132.
Upon receipt of the above funds, each Harquahala Valley
landowner entered into a distribution agreement and release
(Distribution Agreement) with HID under which it was provided
that the landowners would return to HID any “relinquishment
funds” they received if an error in payment occurred or if HID
incurred a liability necessitating the use of the funds.
There is no express provision in the Distribution Agreement
indicating that the distribution occurred in exchange for any
right of the landowners in Colorado River water. - 12 -
At the time of the 1992 Master Agreement, the local water
distribution system that was connected to CAP and that was
maintained by HID was complete. HID agreed to continue to
maintain and operate this water distribution system in subsequent
years, by purchasing water on the open market and distributing
and selling water to the Harquahala Valley landowners and to
others as the landowners and others decided to purchase water
from HID at market rates. The CAP Water District was one of the
sources from which HID might purchase water in subsequent years,
depending on the price of water available through CAP in
comparison to the price of water available from other sources.
After relinquishment to the Interior Department of the water
rights by the Harquahala Valley landowners, the water rights were
reallocated to other users of Colorado River water.
On March 21, 1994, the Inspector General of the Interior
Department issued an audit report regarding the Master Agreement
and relinquishment by HID of its Colorado River water rights.
This report faulted the Interior Department in the negotiations
relating to relinquishment of HID’s water rights and for
discounting the value of HID's debt obligation to the Federal
Government to a present value (as of the end of 1992) of $5.8
million, which was factored into the computation of the payment
to HID of $28.7 million. This report also stated that the
Harquahala Valley landowners “unduly benefited” by receipt of
$24.6 million in connection with relinquishment of the water
rights. - 13 -
On June 5, 1995, the U.S. General Accounting Office issued a
report to a congressional committee regarding relinquishment by
HID to the Interior Department of its Harquahala Valley water
rights. Therein, that transaction is described as a “sale of a
water entitlement” by the Harquahala Valley landowners.
Discussion
Capital Asset Treatment of Water Rights
As explained, petitioners contend, as a matter of law and
partial summary judgment, that the water rights of the
partnership constitute capital assets and that relinquishment
thereof by the partnership constituted a sale or exchange.
Respondent contends, also as a matter of law and partial summary
judgment, that relinquishment by the partnership of water rights
did not constitute a sale or exchange of a capital asset and
therefore that the $1,088,132 the partnership received in 1993
should be treated as ordinary income.
In order for contract rights to qualify as capital assets
under section 1221, the contract rights must constitute
“property” of the taxpayer and not constitute any of the five
types of property excluded from capital gain treatment under
section 1221(1) through (5) (namely, (1) inventory;
(2) depreciable personal property or real property used in a
trade or business; (3) certain intangible property; (4) accounts - 14 -
receivable acquired in a trade or business; and (5) certain
governmental publications).1
1 Sec. 1221 provides as follows:
SEC. 1221. CAPITAL ASSET DEFINED.
For purposes of this subtitle, the term “capital asset” means property held by the taxpayer (whether or not connected with his trade or business), but does not include--
(1) stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business;
(2) property, used in his trade or business, of a character which is subject to the allowance for depreciation provided in section 167, or real property used in his trade or business;
(3) a copyright, a literary, musical, or artistic composition, a letter or memorandum, or similar property, held by--
(A) a taxpayer whose personal efforts created such property,
(B) in the case of a letter, memorandum, or similar property, a taxpayer for whom such property was prepared or produced, or
(C) a taxpayer in whose hands the basis of such property is determined, for purposes of determining gain from a sale or exchange, in whole or part by reference to the basis of such property in the hands of a taxpayer described in subparagraph (A) or (B);
(4) accounts or notes receivable acquired in the ordinary course of trade or business for services rendered or from the sale of property described in paragraph (1);
(5) a publication of the United States Government (continued...) - 15 -
Neither party herein suggests that any of the above five
statutory exceptions applies to the water rights in issue.
Petitioners, in their briefs, note that if the water rights in
issue were to be treated as “real property” used in the trade or
business of the partnership's farming activity, and therefore as
excluded from capital asset treatment under section 1221, gain
realized on the sale of the water rights would, in any event, be
treated as capital gain under section 1231. Neither party,
however, pursues this possible treatment of the partnership's
water rights as section 1231 “real property”. Thus, the only
question before us is whether the partnership's water rights
constitute “property” and capital assets under section 1221.2
1 (...continued) (including the Congressional Record) which is received from the United States Government or any agency thereof, other than by purchase at the price at which it is offered for sale to the public, and which is held by--
(A) a taxpayer who so received such publication, or
(B) a taxpayer in whose hands the basis of such publication is determined, for purposes of determining gain from a sale or exchange, in whole or in part by reference to the basis of such publication in the hands of a taxpayer described in subparagraph (A). 2 The fact that the water rights involved herein constitute surface water rights, rather than in situ water rights, may explain why petitioners do not argue that the water rights qualify as “real property” and therefore qualify for capital gain treatment under sec. 1231. - 16 -
The policy considerations and rule of construction
concerning what constitutes capital assets have been explained as
follows:
The preferential treatment afforded by the capital gains provisions, 26 U.S.C.A. secs. 1201-1202, 1221- 1223, was designed “to relieve the taxpayer from * * * excessive tax burdens on gains resulting from a conversion of capital investment * * *.” Burnet v. Harmel, 287 U.S. 103, 106, 53 S.Ct. 74, 75, 77 L.Ed. 199. In Commissioner of Internal Revenue v. Gillette Motor Transport, Inc., 364 U.S. 130, 134, 80 S.Ct. 1497, 1500, 4 L.Ed.2d 1617, the Court held that it was “the purpose of Congress to afford capital-gains treatment only in situations typically involving the realization of appreciation in value accrued over a substantial period of time, and thus to ameliorate the hardship of taxation of the entire gain in one year.” Commissioner of Internal Revenue v. P.G. Lake, Inc., supra; Burnet v. Harmel, supra. * * * [Wiseman v. Halliburton Oil Well Cementing Co., 301 F.2d 654, 658 (10th Cir. 1962).]
See also Freese v. United States, 455 F.2d 1146, 1150 (10th Cir.
1972); Elliott v. United States, 431 F.2d 1149, 1155 (10th Cir.
1970).
As we have previously explained, see Foy v. Commissioner,
84 T.C. 50, 65-70 (1985), no single definitive explanation is
available of what types of property qualify as capital assets
under section 1221.
Over the years, court decisions have recognized limitations
on the types of property which qualify as capital assets under
section 1221. In Corn Prods. Ref. Co. v. Commissioner, 350 U.S.
46, 51 (1955), assets that were an integral part of a taxpayer's
business were held not to qualify as capital assets. In that - 17 -
case, the Supreme Court held that although corn futures contracts
did not fall expressly within the statutory exclusions, profits
received from the purchase and sale of futures contracts entered
into in order to assure a reasonably priced supply of corn
inventory for the taxpayer's business did not qualify for capital
gain treatment. The Court observed that “Congress intended that
profits and losses arising from the everyday operation of a
business be considered as ordinary income or loss rather than
capital gain or loss.” Id. at 52.
In 1988, in Arkansas Best Corp. v. Commissioner, 485 U.S.
212, 219 (1988), the Supreme Court clarified that the Corn Prods.
judicial exception is more properly interpreted as involving an
application of the statutory exception for inventory under
section 1221(1). See also FNMA v. Commissioner, 100 T.C. 541,
573 (1993). As explained, respondent does not contend that
petitioners' contract rights fall within the inventory exception
to capital asset treatment.
Another limitation on the types of property which qualify
for treatment as capital assets was explained by the Supreme
Court in Commissioner v. P.G. Lake, Inc., 356 U.S. 269 (1958).
Thereunder, a mere right to receive ordinary income generally
will not qualify as a capital asset. The issue in Commissioner
v. P.G. Lake, Inc., supra, was whether a transfer of royalty
rights associated with the production of oil constituted sale of
a capital asset. After the transfer, the taxpayer retained a
reversionary interest in the underlying oil and gas leases, and - 18 -
the purchaser acquired nothing more than a right to receive a
portion of the royalties for a limited time. The Supreme Court
noted that the amount received for the transfer was virtually
equivalent to the amount of royalty income that otherwise would
have been received. The Supreme Court concluded that the only
right the taxpayer sold was the right to receive ordinary income
and held that the royalty right did not constitute a capital
asset. The Supreme Court noted as follows:
The substance of what was assigned was the right to receive future income. The substance of what was received was the present value of income which the recipient would otherwise obtain in the future. In short, consideration was paid for the right to receive future income, not for an increase in the value of the income-producing property. [Id. at 266.]
Subsequent decisions have attempted to clarify the holding
of the Supreme Court in P.G. Lake, Inc. With respect to the
broad proposition that amounts received for the transfer of a
right to receive future income will not qualify for capital gain
treatment, the Court of Appeals for the Fifth Circuit in United
States v. Dresser Indus., Inc., 324 F.2d 56 (5th Cir. 1963),
explained--
As a legal or economic position, this cannot be so. The only commercial value of any property is the present worth of future earnings or usefulness. If the expectation of earnings of stock rises, the market value of the stock may rise; at least a part of this increase in price is attributable to the expectation of increased income. The value of a vending machine, as metal and plastic, is almost nil; its value arises from the fact that it will produce income. [Id. at 59.] - 19 -
In applying the P.G. Lake, Inc. limitation on what property
qualifies as a capital asset, courts generally consider the
entire economics of a transaction, as suggested by Dresser
Indus., Inc. in the above quotation, and evaluate all of the
rights of the taxpayer, as well as all of the risks and
obligations of the taxpayer associated with ownership of the
property before the transfer. For example, in an attempt to
explain P.G. Lake, Inc., we stated in Guggenheim v. Commissioner,
46 T.C. 559 (1966)--
The Court in Lake was faced with the problem whether a transfer of part of a capital asset is itself the transfer of a capital asset. That part was defined and delineated by the taxpayer in such a manner as to consist essentially of only the rights to income. The transferee assumed few of the risks identified with the holding of a capital asset; he assumed only a nominal risk of his oil payment right decreasing in value and none of the possibility of the oil payment right increasing in value. On the other hand, the taxpayer, after the transfer, retained essentially all of the investment risks involved in his greater interest to the same extent as before the transfer. [Id. at 569.]
The above statement implies that whether investment risks are
associated with contract rights transferred is a particularly
relevant consideration in determining whether the rights are to
be treated as capital assets.
In Commissioner v. Ferrer, 304 F.2d 125, 130 (2d Cir. 1962),
revg. in part and remanding 35 T.C. 617 (1961), the Court of
Appeals for the Second Circuit concluded, among other things,
that where a taxpayer's “bundle of rights” reflected “something
more than an opportunity, afforded by contract, to obtain - 20 -
periodic receipts of income,” and where they included “equitable
interests” similar to those of an owner of property, they were to
The basic proposition of Commissioner v. P.G. Lake, Inc.,
supra at 265, is still viable. Where a taxpayer merely
“[substitutes] the right to receive ordinary income from one
source for the right to receive ordinary income from another
[source],” the rights transferred will not be considered a
capital asset. United States v. Dresser Indus., Inc., supra
at 59; see also Arkansas Best Corp. v. Commissioner, supra at 217
n.5.
To summarize, in determining whether a taxpayer's contract
rights that are transferred constitute capital assets, courts
generally consider all aspects of the taxpayer’s bundle of rights
and responsibilities that are transferred, specifically including
the following six factors:
(1) How the contract rights originated;
(2) How the contract rights were acquired;
(3) Whether the contract rights represented an equitable interest in property which itself constituted a capital asset;
(4) Whether the transfer of contract rights merely substituted the source from which the taxpayer otherwise would have received ordinary income;
(5) Whether significant investment risks were associated with the contract rights and, if so, whether they were included in the transfer; and - 21 -
(6) Whether the contract rights primarily represented compensation for personal services. [Foy v. Commissioner, 84 T.C. at 70.]
Both parties herein rely on certain Supreme Court cases that
involve general, nontax issues regarding water rights. See
Nevada v. United States, 463 U.S. 110 (1983); Ickes v. Fox, 300
U.S. 82 (1937). At issue in Nevada were rights of landowners to
water from the Truckee River in Nevada. At issue in Ickes were
rights of landowners to water from the Sunnyside Unit of the
Yakima Project in Washington. The water rights in both cases
were based on the Reclamation Act, ch. 1093, 32 Stat. 388 (1902).
In Nevada v. United States, supra at 126, the Supreme Court
explained that "the beneficial interest in the rights confirmed
to the Government resided in the owners of the land within the
Project to which these water rights became appurtenant upon the
application of Project water to the land," and that "the law of
Nevada, in common with most other western States, requires for
the perfection of a water right for agricultural purposes that
the water must be beneficially used by actual application on the
land."
In Ickes v. Fox, supra at 94-95, the Supreme Court stated:
Although the government diverted, stored and distributed the water, the contention of petitioner that thereby ownership of the water or water-rights became vested in the United States is not well founded. Appropriation was made not for the use of the government, but, under the Reclamation Act, for the use of the land owners; and by the terms of the law and of the contract already referred to, the water-rights became the property of the land owners, wholly distinct - 22 -
from the property right of the government in the irrigation works. * * *
As stated, the water rights and allocations involved in both
Nevada and Ickes were based on the Reclamation Act passed by
Congress in 1902. Thereunder, it was expressly provided that
"the right to the use of water acquired under the provisions of
this Act shall be appurtenant to the land irrigated, and
beneficial use shall be the basis, the measure, and the limit of
the right." Ch. 1093, sec. 8, 32 Stat. 390.
Consistently with the above statutory language, the
underlying contracts involved in Nevada between the U.S.
Government and the landowners provided generally “for a permanent
water right for the irrigation of and to be appurtenant to all of
the irrigable area now or hereafter developed under the [Newlands
Reclamation Project]”. Nevada v. United States, supra at 127
n.9. Similarly, the underlying contracts involved in Ickes
between the U.S. Government and the landowners provided generally
that the “rights shall be, and thereafter continue to be, forever
appurtenant to designated lands owned by such shareholders.”
Ickes v. Fox, supra at 89.
Petitioners argue that the above language from Nevada and
Ickes supports a conclusion that the Harquahala Valley
landowners’ water rights under the Subcontract were appurtenant
to the landowners’ land.
Respondent relies on the same cases and emphasizes
differences in the relevant Federal law and the underlying - 23 -
contracts that were involved in those cases and in the Boulder
Canyon Project Act that is involved in the instant case.
We now apply the law, as set forth and discussed above, to
the undisputed facts of this case. The participation and rights
of the partnership in which petitioners invested in Colorado
River water originated in 1983 only as a result of and in direct
proportion to the partnership’s ownership interest in Harquahala
Valley land. The 1983 allocation of water rights to HID under
the Subcontract and through HID to the partnership under Arizona
law was directly linked to and dependent upon the partnership’s
ownership of the land and on irrigation of the land in prior
years.
Ariz. Rev. Stat. Ann. sec. 48-2990, relating to water rights
and irrigation districts, and under which the partnership in 1983
received its Colorado River water rights, provides in part as
follows: "Subject to the law of priority, all water of the
district available for distribution shall be apportioned to the
lands thereof pro rata".
The water rights of the partnership were linked to the
partnership’s ownership interest in the land, to its farming
operations and activities on the land, and to its capital
investment in the land. The water rights, and particularly the
decision in 1992 to relinquish the water rights, affected the
partnership’s farming activity and the investment risks
associated with that farming activity--especially the financial
risks associated with purchasing water on the open market. - 24 -
From 1983 through 1992, use of the water rights did not
produce for the partnership, in any direct or immediate sense,
ordinary income. Rather, using water received, land was planted,
fertilized, and irrigated. Crops grew. Eventually, crops were
harvested, transported, and sold. The water rights at issue
simply represent one component of the partnership’s investment in
and operation of its farming activity.
Certainly, the $1,088,132 the partnership received in 1993
upon relinquishment of the water rights did not represent merely
a substitute for ordinary income the partnership otherwise would
have received. Rather, it represented payments the partnership
received in exchange for making a shift in one significant aspect
of its farming activity; i.e., a shift in the source of its
irrigation water from the Colorado River at fixed prices to the
market place at market prices.
The above undisputed facts surrounding the origination,
allocation, and use of the water rights support the conclusion
that the partnership’s water rights should be treated as capital
assets. We so hold.
In spite of differences between the language of the
Reclamation Act, involved in Nevada v. United States, supra, and
Ickes v. Fox, supra, and the language of the Boulder Canyon
Project Act, involved in the instant case, we agree generally
with petitioners that such differences in the underlying
statutory language and in the above nontax opinions of the
Supreme Court do not support a conclusion that the water rights - 25 -
involved herein do not constitute capital assets of the
partnership. To the contrary, as we read the above authority, we
believe they support the conclusion that the water rights
allocated to the partnership for use in its farming activity,
constitute contractual rights that are to be regarded as integral
to the partnership's farming activity (whether technically
appurtenant to the land or not) and as capital assets of the
partnership.
Respondent acknowledges that the water rights of HID
constitute capital assets. For purposes of analyzing the capital
asset character of the water rights, we perceive little
difference between HID's rights in Colorado River water and the
allocations the partnership received through the HID in Colorado
River water. We note, in particular, Ariz. Rev. Stat. Ann. sec.
48-2990, under which water districts must distribute all water
available for distribution "to the lands thereof pro rata”, and
Ariz. Rev. Stat. Ann. sec. 48-2902 (West 1997), under which water
districts are not allowed to divert allocated water from
landowners having a prior right to such water to other purposes
without first compensating the landowners.
Lastly, we note that respondent's rulings often treat as
capital assets allocations or rights that taxpayers receive from
governmental agencies. See Rev. Rul. 66-58, 1966-1 C.B. 186
(cotton acreage allotments treated as capital assets); Rev. Rul.
70-644, 1970-2 C.B. 167 (milk allocation rights treated as
capital assets); see also Madera Irrigation Dist. v. Hancock, 985 - 26 -
F.2d 1397, 1401 (9th Cir. 1993) (the parties and the Court of
Appeals for the Ninth Circuit treated water rights as property
rights protected by the Fifth Amendment); First Victoria Natl.
Bank v. United States, 620 F.2d 1096, 1106-1107 (5th Cir. 1980)
(rice production histories and rights to receive allotments of
rice, if and when issued, were treated as property rights
includable in a decedent's gross estate).
On this issue, we grant petitioners' motion for partial
summary judgment, and we deny respondent's motion for partial
summary judgment.
Sale or Exchange
If petitioners' water rights in Colorado River water are to
be treated as capital assets, petitioners and respondent cross-
move for partial summary judgment on the issue of whether, for
Federal income tax purposes, relinquishment of the water rights
by the partnership and receipt of $1,088,132 by the partnership
constituted a sale or exchange. Respondent contends that the
$1,088,132 was transferred to the partnership either for the
partnership’s commitment to indemnify HID for unexpected future
liabilities that might arise or as a mere windfall distribution
to the partnership of HID surplus funds.
The undisputed evidence establishes that the form and
substance of the transfers of funds that occurred at both levels
(from CAP to HID and from HID to the partnership) were based on
and occurred as a result of the partnership’s relinquishment or - 27 -
exchange of rights to Colorado River water. Respondent's
contention that the transfer of funds from HID to the partnership
did not constitute a sale or exchange but was based on some
indemnification commitment or windfall distribution of surplus
funds ignores the substance of the transaction by which the
partnership relinquished its water rights in return for the
$1,088,132.
The mere reference in the 1993 Distribution Agreement to a
boilerplate and routine indemnification commitment and to the
possibility that the landowners might be required to return to
HID some portion of the funds received does not control the
treatment of the transaction.
The funds were labeled "relinquishment funds”, and that is
what the funds constituted. The funds were received in exchange
for relinquishment of the water rights. They were not labeled
and they did not constitute indemnification funds, surplus funds,
or windfall funds.
Respondent argues that HID was not required to distribute
any of the funds to the partnership. Assuming arguendo that
respondent is correct, the significant facts are that HID did
distribute those funds to the partnership and that HID did so
only in exchange for relinquishment of the partnership’s water
rights.
Respondent notes that the partnership and other Harquahala
Valley landowners were not named parties to the Master Agreement,
that under the Master Agreement no third-party beneficiaries were - 28 -
provided for, and that under the Distribution Agreement it was
not expressly provided that relinquishment of the water rights
occurred “in exchange” for the funds distributed.
Respondent’s arguments are without merit. The transaction
before us constitutes a sale or exchange by the partnership of
water rights for the $1,088,132 received by the partnership.3
We grant petitioners' motion for partial summary judgment on
this issue.
Allocation of Partnership’s Tax Basis in Land to $1,088,132 Partnership Received for Water Rights
If the above issues are resolved in favor of petitioners, as
they are, petitioners and respondent cross-move for partial
summary judgment on the issue as to whether any portion of the
partnership's $675,000 tax basis in its ownership interest in
Harquahala Valley land is allocable to the water rights and
should be available to offset the $1,088,132 the partnership
received in 1993 upon relinquishment of the water rights.
Petitioners contend that under the 1983 Subcontract and
under Arizona State law, the partnership’s water rights
constituted part of the bundle of rights represented by land
3 We note that neither party relies on court opinions involving so-called vanishing or disappearing assets. See, e.g., Nahey v. Commissioner, 111 T.C. 256 (1998); Towers v. Commissioner, 24 T.C. 199 (1955), affd. 247 F.2d 233 (2d Cir. 1957); Hudson v. Commissioner, 20 T.C. 734 (1953), affd. per curiam sub nom. Ogilvie v. Commissioner, 216 F.2d 748 (6th Cir. 1954). Because the water rights that HID and the partnership relinquished to the Interior Department reverted to the Interior Department, survived, and were reallocated to other users, those opinions would appear inapplicable to the instant controversy. - 29 -
ownership that the partnership held, that the water rights could
be neither bought nor sold separately by the partnership, and
therefore that the partnership's $675,000 cost of purchasing the
land in 1976 should be applied against the $1,088,132 the
partnership received in 1993 on relinquishment of the water
Because the water rights were received and sold by the
partnership separately from the land, respondent argues that no
allocation should be allowed of the partnership's land costs to
the funds the partnership received for the water rights.
For Federal income tax purposes, the general rule provides
that taxpayers recover tax free their cost or tax basis for
property on which gain is to be computed. See sec. 1001(a).
Section 1016(a)(1) provides in pertinent part that--
adjustment * * * [to basis shall be made]
(1) for expenditures, receipts, losses, or other items, properly chargeable to capital account * * *
Petitioners contend that under section 1016, where property
that is sold does not have a separate, identifiable cost or tax
basis and where the property sold is sufficiently integrated with
or appurtenant to related property, the taxpayer’s total cost for
the related property should be charged to the transaction and
only after the taxpayer’s total cost for the related property is
recovered should the taxpayer be required to recognize any
taxable capital gain on the property sold. - 30 -
More specifically with regard to the facts of this case,
petitioners contend that in 1976 when the partnership acquired
its interest in Harquahala Valley land, the partnership
simultaneously acquired an expectation of future water rights and
that the water rights that were acquired by the partnership in
1983 should be regarded as sufficiently related to or appurtenant
to the land to justify allocating the partnership's 1976 $675,000
cost of purchasing the land to the $1,088,132 the partnership
The facts relevant to this issue are clear, and on this
issue, neither party suggests any material facts in dispute. In
1976, when it acquired its interest in Harquahala Valley land,
and thereafter until 1983, the partnership did not have vested
property rights in Colorado River water.
In 1983, the partnership acquired, and in 1992, the
partnership relinquished, Colorado River water rights separately
from any acquisition or sale of its ownership interest in the
land. Before 1983, the partnership acquired the land without any
vested interest in Colorado River water. After 1992 (after its
water rights had been relinquished), the partnership owned the
same interest in the same land it acquired in 1976.
On these facts, no portion of the partnership's original
land acquisition cost or tax basis in the Harquahala Valley land
is properly allocable to the water rights the partnership
received in 1983 and sold or relinquished in 1992. - 31 -
Petitioners and respondent rely on various cases, Arizona
law, and other authority. In Inaja Land Co. v. Commissioner,
9 T.C. 727, 736 (1947), because it was impossible to allocate
with reasonable accuracy a separate cost to easements the
taxpayer sold, the Court allocated the taxpayer's cost of
underlying land to funds received on sale of the easements. The
taxpayer in Inaja, however, in 1928 had purchased the land not
just with an expectation but with a legal right not to have the
land flooded from unexpected upstream water sources. In
subsequent years, in connection with construction of a tunnel,
the taxpayer’s land located downstream from the tunnel was
flooded, and the responsible government agency paid the taxpayer
a lump sum for the easement to flood the taxpayer's land.
In Trunk v. Commissioner, 32 T.C. 1127, 1139 (1959),
payments received for relinquishment of a right to a possible
condemnation award were treated as received in exchange for a
capital asset. We also held that because it was impossible or
impracticable to ascertain the taxpayer's specific cost basis for
the right that was relinquished, which was derived from the
taxpayer's right of ownership in the entire property, the
payments received were to be offset by the taxpayer's cost basis
in the entire property. In the instant case, however, the
partnership's ownership of the land was not acquired with any
vested right to Colorado River water. Trunk is distinguishable. - 32 -
The parties refer to Rev. Rul. 66-58, 1966-1 C.B. at 187, in
which the tax treatment of the sale of cotton acreage allotments
was addressed. In the ruling, it is stated that--
Where a taxpayer has acquired * * * [a cotton] allotment along with the land to which it relates, as a unit, the cost or other basis of the entire unit should be allocated between the land and the allotment in accordance with the relative fair market values of such properties on the date of acquisition. * * *
The ruling, however, also explains--
Of course, no portion of the basis of land, acquired prior to the issuance of the cotton allotment, can be allocated to such allotment.
Our discussion of the partnership's water rights in the
context of the above capital asset issue (namely, among other
things, that water rights the partnership received in 1983
related to and were dependent upon the land the partnership
acquired in 1976) is not inconsistent with our analysis and
holding on the instant issue that the water rights were
sufficiently distinct and separate from the partnership's
ownership interest in the land to preclude any allocation of the
partnership's cost or tax basis in the land to the partnership's
The partnership's water rights were related to and dependent
upon the partnership's land ownership, and the partnership's
water rights constituted capital assets of the partnership. At
the same time, however, as discussed, the partnership's water - 33 -
rights were received in 1983, years after the land was acquired
in 1976, and in a separate transaction. The partnership then, in
1992, sold the water rights separately from the land and retained
the same land it had acquired in 1976.
Impossibility of Allocation of Portion of Tax Basis in Land
If the above issues are resolved in favor of petitioners,
petitioners move for partial summary judgment on the issue as to
whether, on the facts of this case, it would be impossible to
allocate a specific portion of the partnership's total cost or
tax basis in its land to the funds the partnership received for
the water rights. Because of the alleged impossibility of
allocating any specific portion of the partnership's land cost to
the water rights, petitioners, as a matter of summary judgment,
would allocate the partnership's total $675,000 tax basis in the
land to the $1,088,132 the partnership received for the water
If we address this issue, respondent objects to partial
summary judgment on the ground that material facts remain in
dispute as to what an appropriate allocation would be of the
partnership’s tax basis in the land to the funds the partnership
received for the water rights. - 34 -
In light of our conclusion and holding in respondent’s favor
on the prior issue (viz, that no allocation of the partnership’s
cost and basis in the land is to be allocated to the water
rights), we need not address this issue.
To reflect the foregoing,
An appropriate order
will be issued.