1031 Exchanges of Water Rights (Riparian Rights)
The tax-deferred exchange of properties or assets for other properties or assets pursuant to Section 1031 of the Internal Revenue Code requires that the various properties involved in the 1031 exchange be like-kind to each other. The determination as to whether properties are like-kind to each other is relatively easy in most 1031 exchange transactions.
State Law Governs
Water shares are another name for a form of Riparian Rights, which are rights a land owner has to waterways that are contiguous to property that is owned. Under the Common Law, riparian rights allow a landowner to withdraw water from the contiguous body of water. Today most riparian rights are restricted in one or more ways; either the duration of the rights, the priority among different classes of property owners on withdrawing water (usually municipalities will have the first priority, in some Western States, native Americans will have the second priority, with everyone else as the third priority), and/or the quantity of water that can be withdrawn.
There has been a tax court case and a PLR on this subject. In 2002, in a tax court case out of Arizona, the court concluded that the nature and extent of the restrictions prevented the taxpayer from reinvesting the sale proceeds from his riparian rights into fee simple in new farmland. The court indicated that the riparian rights were not “like kind” to fee simple. In The Private Letter Request, on similar, but not identical facts, the Service indicated that a taxpayer’s riparian rights were “like kind” to fee simple in new farmland. In another tax court case from last year, Peabody vs Commissioner, the court went through an extended discussion of the issue of when something less than fee simple is still like kind to full fee simple. Bottom line, were the rights are significant enough, they will be like kind. Peabody did not come up with a definitive test. However, a perpetual right certainly would be like kind to fee, and as was the case in the PLR, some restrictions will not disallow the like kind finding. So, in part, it requires an analysis and a judgment call in trying to quantify how extensive the rights being sold are (and what, if any. restrictions are imposed on those rights).
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Rev. Rul. 55-749, 1955-2 C.B. 295 holds that where, under applicable state law, water rights are considered real property rights, the exchange of perpetual water rights for a fee interest in land constitutes a nontaxable exchange of property of like kind within the meaning of Section 1031(a).
Riparian rights - The rights of owners of lands bordering watercourses which relate to the water and its use.
Riparian rights
Special rights of people who own land that runs into a river bank (a "riparian owner" is a person who owns land that runs into a river). While not an ownership right, riparian rights include the right of access to, and use of the water for domestic purposes (bathing, cleaning and navigating). The extent of these rights varies from country to country and may include the right to build a wharf outwards to a navigable depth or to take emergency measures to prevent flooding.
