A Fox Rothschild team secured a favorable private letter ruling, PLR 202309007, from the Internal Revenue Service, which held that certain water rights are “real property,” and therefore qualify for a tax-deferred exchange under Internal Revenue Code Section 1031.
Gregory A. Novotny, Co-Chair of the Taxation and Wealth Planning Department, who with Chantal C. Renta, requested the private letter ruling, said the recently released ruling was the first of its kind and could provide greater comfort and clarity to other taxpayers seeking to enter into similar water rights transactions.
“This provides some critical guidance in an area where there’s not very much guidance. It could help people who want to exchange all or a portion of their water rights for real property and gives them some comfort that they have the option to utilize a Section 1031 exchange,” Novotny said.
The Fox attorneys represented ranch owners who wanted to sell a portion of their water rights to divert water from a river to a third party, and to use the proceeds to buy real property under a Section 1031 exchange, one of the most frequently used tax planning strategies in the Code.
Under a 1031 exchange, taxpayers are allowed to exchange like-kind real property without recognizing the gain from such an exchange. For purposes of a 1031 exchange, real property is determined under state and local law with a few exceptions in the Treasury Regulations.
The client held a license in perpetuity for the diversion and use of water during specified months.
“The critical issue was whether or not these water rights, which permit the diversion of a specified amount of water per a day during specified months, are real property under state law,” Novotny said.
“What the ruling provides is that because these water rights never terminate and could continue in perpetuity so long as there is water in the river, the water rights are treated like an apartment building or a plot of land would be,” he said.
The Fox attorneys cited statutes and case law supporting the characterization of the water rights as real property under state law. Given the facts and law of the state, the IRS agreed with the ranch owners’ position that their water rights are real property for the purposes of Section 1031.
Since the issuance of PLR 202309007, several prominent tax news organizations have written posts about the significance of this novel ruling. The Fox attorneys anticipate that this ruling will impact future tax-deferred exchanges for years to come.
Original source can be found here.