1031 Exchange for Water Rights and Easements

A water right is like-kind to land only if it is perpetual and real property under state law

Rev. Rul. 55-749 set the standard in 1955, and the Tax Court quoted its rationale in Peabody: 'where the water right, whatever its size, is in perpetuity, as distinguished from a right to a specific total amount of water or to a specific amount of water for a limited period, the water rights and the land involved are regarded as sufficiently similar to constitute property of a like kind.' The ruling also required that state law treat the right as real property, which the Arizona court in Wiechens accepted for Arizona water rights.

Wiechens v. United States (D. Ariz. 2002) is the failing side of that line. A farm partnership sold its Central Arizona Project water back to the government and bought farmland; the rights came from a 1983 subcontract limited to 7.67% of CAP agricultural supply, irrigation use only, subordinate to municipal and Indian users in a shortage, and a 50-year term. The court held the rights were 'limited in priority, quantity, and duration' and not like-kind to the farmland, and it refused to stretch the 30-year leasehold safe harbor to cover them.

Shares in a mutual ditch, reservoir or irrigation company sit on the regulation's list of real-property intangibles only if a state statute or the state's highest court has recognized them as real property. The former statutory rule in §1031(i) was struck in 2017, but the same test now lives in Reg. §1.1031(a)-3(a)(5)(i), so check your state before assuming your ditch stock can be exchanged.

Permanent easements and rights-of-way exchange like a fee; a term easement is real property but not like-kind

Rev. Rul. 72-549 held that a permanent easement and right-of-way granted to an electric utility were like-kind to real property with nominal improvements and to real property improved with an apartment building. PLR 200201007 extended that reasoning to a perpetual conservation easement over an 11,500-acre ranch: under the state statute the easement 'shall constitute an interest in real property notwithstanding the fact that it is negative in character', so the co-owners could grant it to a conservation organization and receive the fee in a second ranch without recognizing gain.

Duration still matters. The preamble to TD 9935 states that 'duration of an easement or a leasehold is not relevant in determining whether the easement or leasehold is real property' under §1.1031(a)-3(a)(5), but that duration 'may be relevant under §1.1031(a)-1(c)' to whether the exchange is like-kind. A 25-year pipeline or solar easement is therefore real property whose sale is fully taxable, because a term interest is not equivalent to a fee.

Cell-tower and billboard ground leases raise the same term question and have their own page in this series. For an easement, ask two things before you sign: is it perpetual, and does the state statute or case law call it an interest in real property?

Selling a conservation easement: apportion basis first, then exchange the proceeds

Granting an easement over land you keep is the sale of part of a larger property. Treas. Reg. §1.61-6(a) requires that 'the cost or other basis of the entire property shall be equitably apportioned among the several parts', and it adds that gain 'shall be determined at the time of sale of each part and not deferred until the entire property has been disposed of.' An appraisal of the land before and after the easement supports the apportionment.

Hypothetical: a 500-acre ranch with a $1,000,000 basis appraises at $5,000,000 before the easement and $3,000,000 after. The easement sells for $2,000,000, 40% of the value, so it takes 40% of the basis ($400,000) and produces $1,600,000 of gain, while the retained ranch keeps $600,000 of basis. Sending the $2,000,000 to a qualified intermediary and buying a DST or net-leased building defers the entire $1,600,000.

If you sell to a land trust or agency for less than appraised value and claim a §170 deduction for the difference, §1011(b) limits the basis you may use against the sale price to 'that portion of the adjusted basis which bears the same ratio to the adjusted basis as the amount realized bears to the fair market value'. The remainder of the basis belongs to the donated portion and never offsets the cash.

How the QI paperwork works when the 'property' is a credit or a recorded restriction

PLR 200649028 is the template. A ranch owner granted a perpetual stewardship easement to a county in return for transferable stewardship credits; the owner assigned its contract, the credit agreement and the easement agreement to the QI before the county issued the credits, every party was notified in writing, the buyer of the credits paid the QI, and the QI bought replacement real estate inside the 45- and 180-day windows.

The IRS ruled that the perpetual stewardship easement was like-kind to a fee interest in other real property and that the credit proceeds could fund the replacement. The lesson for any easement or water-right seller is sequencing: the QI must be in the agreements before the deed or the credits change hands, because money that reaches you first cannot be put back into an exchange.

Development rights and mitigation-type credits: the paper interests that qualify

Land development rights are named in Reg. §1.1031(a)-3(a)(5)(i). In PLR 200805012 a corporation sold a building through a QI and bought transferable development rights in a rezoned city corridor to enlarge a second building it owned; the rights were 'as-of-right and not discretionary', the ordinances set no expiration date, and state tax law defined an interest in real property to include development rights. The IRS ruled the rights like-kind to the fee interest that had been sold.

Two features drove both PLRs: perpetuity and a state-law definition that treats the right as an interest in land. Wetland or species mitigation-bank credits have no published ruling I could confirm, so treat them as unsettled and get a private ruling or a written opinion before relying on them as relinquished or replacement property.

Keeping the land and selling the rights, or selling the land and keeping the water

Both directions work when the interest sold is perpetual and real property under state law. In PLR 200201007 the co-owners kept their fee in the original ranch, now burdened by the easement, and exchanged only the easement; in Wiechens the partnership sold its water and kept farming, and the only defect was that the water it sold was contract-limited.

If you sell farmland and reserve the water rights, the reserved rights are simply outside the exchange, and the price should be allocated so the land's basis is not overstated. A later sale of the reserved perpetual rights to a city or district is itself exchangeable, and a perpetual right that a district later converts into a term allocation is the fact pattern to avoid.

For a landowner who wants income without management after the sale, the replacement can be a DST, a single-tenant net-leased property, or another farm; §1031 does not require water to be replaced with water. Have your CPA or attorney confirm the state-law classification and the basis apportionment before the easement or water deed is recorded.