IRS rules that a rancher's perpetual water-diversion rights are "real property" like-kind to land, so they can be swapped tax-free under Section 1031

Plain-English summary

Section 1031 lets a taxpayer swap one piece of real property for another "like-kind" real property
without paying tax on the gain right away. The question here was whether water rights count as
"real property" of a kind that can be exchanged tax-free for land. The taxpayer is one of several
owners of a former ranch (a farming and cattle operation) who hold, as successors to the ranch's
founder, a state-issued license to divert a set flow of water from a river during a diversion season
each year. The taxpayer wants to sell part of those water rights for cash and reinvest in other
real estate. The IRS looked at whether the rights were perpetual or narrowly limited. Because the
license grants a fixed flow of water every year with no expiration (subject only to the state's power
to revoke for non-beneficial use), the IRS concluded the rights are perpetual and are real property
like-kind to a fee simple interest in land, following Rev. Rul. 55-749 and distinguishing Wiechens
v. United States (where water rights limited in duration, quantity, and priority did not qualify). The
IRS did not rule on whether the specific sale-and-reinvestment transaction otherwise qualifies for
Section 1031 nonrecognition, only on the character of the water rights.

Ruling snapshot

• Question: Are perpetual state-licensed water-diversion rights "real property" like-kind to a fee simple interest in land for purposes of IRC § 1031?
• Outcome: approved (favorable ruling on the character of the water rights; no ruling on whether the transaction otherwise qualifies)
• Key authorities: IRC § 1031(a); Treas. Reg. §§ 1.1031(a)-1, 1.1031(a)-3; Rev. Rul. 55-749; Wiechens v. United States, 228 F. Supp. 2d 1080 (D. Ariz. 2002); Koch v. Commissioner, 71 T.C. 54 (1978)

Full text (IRS public release)

 Internal Revenue Service                                          Department of the Treasury
                                                                   Washington, DC 20224

 Number: 202309007                                                 Third Party Communication: None
 Release Date: 3/3/2023                                            Date of Communication: Not Applicable
 Index Number: 1031.02-00, 1031.03-00
                                                                   Person To Contact:
 --------------------------------                                  ---------------------------, ID No. ---------------
 -------------------------------                                   -----------------
 -------------------------------------------------                 Telephone Number:
 ------------------------------------------------------------      --------------------
 ---------------                                                   Refer Reply To:
 ------------------------                                          CC:ITA:B05
 -------------------------------                                   PLR-112098-22
                                                                   Date:
                                                                   December 06, 2022




Legend

Taxpayer                               =        ------------------------------------------------------------------------
                                       ---------------------------------------------------------------------------------
                                       ----------------------------------------------------------------
Founder                                =        ------------------------------
Ranch                                  =        -------------------
Ranch Owners                           =        --------------------------------------------------------------------
                                       -----------------------------------------------------------------------------
                                       -----------------------------------------------------------------------------
                                       -------------------------
State A                                =        ------------
License                                =        -----------------------------------------------------
Year 1                                 =        ------
Date A                                 =        ----------------
x                                      =        --------
y                                      =        ----
z                                      =        --------
A                                      =        --------
B                                      =        --------
C                                      =        --------
D                                      =        ----------
City                                   =        --------------------------
County                                 =        --------------------------------------
River                                  =        ---------------------
Diversion Season                       =         ------------------------------
------------------------------------
Dear --------------:


This is in response to a request for a Private Letter Ruling dated June 10, 2022, filed on
behalf of Taxpayer by its authorized representative. Taxpayer is requesting that the
Internal Revenue Service issue a ruling that certain water rights described below are
"real property" as that term is used in § 1031 of the Internal Revenue Code ("Code")
and the Treasury Regulations issued pursuant to it and are like kind to a fee simple
interest in real property for purposes of § 1031, provided that the properties are held for
productive use in a trade or business or for investment.

                                           FACTS

In Year 1, Founder began Ranch and was the original licensee of a License for the
diversion and use of water issued by State A, having a priority date of Date A.
Taxpayer and the other Ranch Owners own approximately x acres of real property
located outside of City in County consisting of the former Ranch. Each of the Ranch
Owners owns its respective property in fee simple. Ranch is a diversified farming and
cattle operation producing crops adjacent to an additional rangeland. Ranch Owners do
not carry on a joint business activity, have never joined in filing a partnership return with
respect to their ownership of their respective properties, and engage in their own
separate business activities.

Ranch Owners are the successors in interest to Founder's rights in the License.
Pursuant to the License, Ranch Owners own the right to divert y cubic feet per second
(about z gallons per minute) ("Diversion Rate") of water from River during Diversion
Season each year. If diversions were made at the maximum allowed rate for 24 hours a
day for the Diversion Season, the maximum allowed annual diversion amount would be
A acre-feet. Ranch Owners' rights to use these waters are referred to as the "Water
Rights."

The lands where the diverted water is put to beneficial use for irrigation purposes total B
acres of the Ranch (such portion, the "Land"). Each of the Ranch Owners owns a
specified percentage of the Land. Although the Ranch Owners each own different
percentages of the Land, each has full access to and the right to divert water under the
License. The Ranch Owners have agreed that if all or a portion of the Water Rights are
sold, then the proceeds from such sale shall be allocated in accordance with the Ranch
Owners' relative percentages of the Land owned.

Taxpayer plans to sell a portion of Water Rights and reinvest the proceeds in real
property in a transaction that will qualify for nonrecognition under § 1031 of the Code.
The purpose of such transaction is to diversify the Taxpayer's real estate holdings. The
Taxpayer has concluded that its full portion of Water Rights may not be necessary for its
current business purposes. Taxpayer plans to sell a portion of Water Rights (also
referred to herein as the "Relinquished Property") to an unrelated purchaser ("Buyer")
pursuant to a Purchase and Sale Agreement ("Agreement").

The proposed terms of the Agreement are as follows: Taxpayer agrees to permanently
sell a portion of the License to Buyer; Taxpayer will retain the right to divert C-acre feet
of water; and Buyer agrees to purchase a portion of the License from Taxpayer for $D
per acre foot of water. To determine the total purchase price, the parties will multiply
the per acre foot price by the quantity of water sold. To calculate the quantity of water
sold, the Diversion Rate sold will be multiplied by the number of days of the Diversion
Season sold, which will further be multiplied by -------(i.e., the quantity of water in acre
feet diverted after taking one cubic foot per second for one day).

The Buyer will pay Taxpayer cash in an amount equal to the total purchase price in
exchange for the Relinquished Property. The cash sales proceeds will be allocated
among the Ranch Owners, including Taxpayer, according to their percentage ownership
of the Land. Pursuant to State A administrative procedures, the License will be
bifurcated into two separate licenses: one vested in the Taxpayer and one vested in the
Buyer.

You have requested a ruling that the Water Rights are "real property" as that term is
used in § 1031 of the Code and the regulations thereunder and are like-kind to a fee
simple interest in real property for purposes of § 1031 provided that the properties are
held for productive use in a trade or business or for investment.

                                    LAW AND ANALYSIS

Section 1031(a)(1) of the Code provides that no gain or loss is recognized on the
exchange of real property held for productive use in a trade or business or for
investment if the real property is exchanged solely for real property of like kind that is to
be held either for productive use in a trade or business or for investment.

Section 1.1031(a)-1(b) of the Income Tax Regulations defines "like kind" as referring to
the nature or character of the property and not to its grade or quality. One kind or class
of property may not, under § 1031, be exchanged for property of a different kind or
class. The fact that any real estate involved is improved or unimproved is not material,
for that fact relates only or the grade or quality of the property and not to its kind or
class.

Section 1.1031(a)-1(c)(2) of the Income Tax Regulations provides that no gain or loss is
recognized if a taxpayer who is not a dealer in real estate exchanges city real estate for
a ranch or farm, exchanges a leasehold of a fee with 30 years or more to run for real
estate, or exchanges improved real estate for unimproved real estate.

Section 1.1031(a)-3(a)(1) of the Income Tax Regulations defines the term "real
property" to mean land and improvements to land, unsevered natural products of land,
and water and air space superjacent to land. Under paragraph (a)(5) of this section, an
intangible interest in real property of a type described in this paragraph (a)(1) is real
property for purposes of § 1031 and this section. Property that is real property under
State or local law as provided in paragraph (a)(6) of this section is real property for
purposes of § 1031 and this section.

Section 1.1031(a)-3(a)(5)(i) of the Income Tax Regulations provides that intangible
assets that are real property for purposes of § 1031 and this section include the
following: Fee ownership; co-ownership; a leasehold; an option to acquire real property;
an easement; certain stock in a cooperative housing corporation; shares in a certain
mutual ditch, reservoir, or irrigation companies described in § 501(c)(12)(A) of the Code;
and land development rights. Similar interests are real property for purposes of § 1031
and this section if the intangible asset derives its value from the real property or an
interest in real property and is inseparable from that real property or interest in real
property. Under paragraph (ii), a license, permit, or other similar right that is solely for
the use, enjoyment, or occupation of land or an inherently permanent structure and that
is in the nature of a leasehold, easement or other similar right, generally is an interest in
real property under this section.

Section 1.1031(a)-3(a)(6) of the Income Tax Regulations provides that with certain
exceptions, property is real property within the meaning of paragraph (a)(1) of this
section under State or local law if, on the date it is transferred in an exchange, the
property is real property or an interest in real property under the law of the State or local
jurisdiction in which that property is located.

In Rev. Rul. 55-749, 1955-2 C.B. 295, land was exchanged for perpetual water rights
that were considered real property rights under the applicable state law. Since 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 Service concluded that
the water rights and the land involved were sufficiently similar to constitute property of a
like kind within the meaning of § 1031(a). Accordingly, Rev. Rul. 55-749 holds that the
exchange of perpetual water rights for a fee interest in land is a nontaxable exchange of
like-kind property within the meaning of § 1031.

In Wiechens v. United States, 228 F. Supp. 2d 1080 (D. Az. 2002), the taxpayers
conveyed water rights for a fee interest in farmland. The taxpayer's water rights were
limited in duration to a 50-year period; limited in quantity to a specific percentage of the
overall supply of agricultural water; and limited in priority to be secondary to municipal,
industrial and Indian uses. The District Court refused to equate the taxpayer's water
rights to a 30-year leasehold interest. The Court held that the application of § 1031
"'requires a comparison of the exchanged properties to ascertain whether the nature
and character of the transferred rights in and to the respective properties are
substantially alike.' Factors to be considered in this analysis include 'the respective
interests in the physical properties, the nature of the title conveyed, the rights of the
parties, [and] the duration [of the interests].'" Id., at 1085 (citing to Koch v.
Commissioner, 71 T.C. 54, 65 (1978)). The Court found that because the taxpayer's
water rights were narrowly restricted in priority, quantity, and duration, and although the
taxpayer's water rights constituted an interest in real property, the water rights were not
sufficiently similar to the fee simple interest that it acquired in the farmland to qualify as
like-kind property.

Here, Taxpayer has cited statutes and case law supporting the characterization of the
Water Rights as real property under the law of State A. Further, License grants the
Ranch Owners rights to a set volume of water during the Diversion Season each year.
The Water Rights are not limited to a maximum total amount of water. They are not
dependent on anything other than the physical presence of water in River. There is no
sunset date on these rights. They are perpetual, subject only to the right of State A to
terminate them based on a finding that they are not being put to beneficial use, a
determination subject to judicial review. Accordingly, the Water Rights are real property
that is like kind to a fee interest in real property under Rev. Rul. 55-749.

                                    CONCLUSION

We conclude that the Water Rights are "real property" as that term is used in § 1031 of
the Code and the Treasury Regulations issued pursuant to that section and are like kind
to a fee simple interest in real property for purposes of § 1031, provided that all
properties are held for productive use in a trade or business or for investment.

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter. No determination is made by this letter as to whether the described
transaction otherwise qualifies under § 1031 as an exchange of property for which
Taxpayer will recognize no gain or loss.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative.

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, taxpayers filing their returns electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

                                               Sincerely,



                                               John M. Aramburu
                                               Senior Counsel, Branch 5
                                               Office of Chief Counsel
                                               (Income Tax & Accounting)

Enclosure (1)

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