Ninth Circuit allows basis allocation to expected property rights.

• Author: Koppel, Michael D.

In Gladden, 8/20/01, rev'g 112 TC 209 (1999), the Ninth Circuit ruled that a taxpayer who paid a premium for land based on a "realistic expectation" that it would have future water rights could, on selling the rights, use a basis for them equal to the premium paid when he purchased the land. This ruling allows a taxpayer to have a basis in property Y (in which he did not have a vested interest when he acquired related property X), even if Y did not exist when he acquired X. Gladden applies to biotechnology and scientific areas, in addition to farming, ranching and security transactions.

Under Regs. Sec. 1.61-6(a), when a taxpayer sells part of a larger property, the basis of the entire property is equitably allocated among its parts; the gain or loss on the part sold is the selling price less the basis allocated to that part (allocated lump-sum method). However, when it is "impossible or impractical" to allocate basis among the several parts of a property, the Tax Court has held that a taxpayer need not recognize any gain on the sale of a part until the entire basis of the property has been recovered (cost recovery method); see Inaja Land, 9 TC 727 (1947).

In Gladden, the Gladdens own 50% of the Saddle Mountain Ranch partnership (SMR), which farms land in Arizona. When SMR purchased the land in 1976 for $675,000, the land had no water rights. However, it was located within the boundaries of a municipal irrigation district formed in 1964 to acquire water rights and, in 1968, Congress authorized construction of a project to bring water to the district. The legislation required eligible land to have "a recent irrigation history" when purchased, and SMR's land qualified. In 1983, the local irrigation district obtained rights to distribute water from the Colorado River, and SMR thereby obtained water rights for the land. In 1993, SMR sold the water rights and retained the land. The Gladdens received $543,566 and reported a capital gain of $130,762.

The Service allowed the Gladdens no basis in the water rights, and issued a deficiency notice of $110,809 (based on $543,566 of ordinary income). The Gladdens argued that the water rights were a capital asset or a Sec. 1231 asset eligible for capital-gain treatment. They also argued that all of the land's basis should be used to reduce the gain on sale, because it was impossible to determine how much of the land's basis should be allocated to the water rights.

The Tax Court ruled that the water rights...