## Facts

- A partnership (including William and Nicole Gladden as 50% partners) bought 880 acres of Arizona farmland in 1976 for $675,000.
- At purchase, the land had no present appurtenant water rights, but it lay within an irrigation district and was eligible for future Central Arizona Project (CAP) water because it had a qualifying irrigation history.
- In 1983, the irrigation district obtained CAP water rights and distributed rights to qualifying landowners; the partnership received such rights without paying a separate price at that time.
- The federal government later permitted landowners to sell these water rights to the government without selling the underlying land.
- In 1993, the partnership sold its CAP-related water rights to the government for $1,088,132; the Gladdens’ share was $543,566.
- The Gladdens reported capital gain but reduced it by allocating part of the 1976 land cost basis to the water rights, reporting $130,762 of taxable gain.
- The Commissioner asserted the water rights had zero basis because they were acquired after the land purchase at no additional cost, making the entire proceeds taxable gain.
- The Tax Court granted summary judgment for the Commissioner, treating the water rights as acquired in a separate transaction with no allocable land basis.

## Issues

1. Whether a taxpayer may allocate part of a lump-sum land purchase basis to later-sold irrigation water rights when the purchase price reflected a realistic expectation of obtaining those rights.
2. Whether the Tax Court erred by treating the later-received water rights as a separate, zero-basis acquisition for purposes of computing gain on sale.

## Decision

- The Ninth Circuit reversed the Tax Court’s summary judgment and remanded.
- The court held taxpayers may allocate a portion of the original land basis to the water rights if evidence shows the land price included a premium for the realistic expectation of acquiring such rights.
- The court directed further proceedings to determine the appropriate allocation amount, including whether allocation by relative fair market values at purchase is practical and what premium, if any, was paid for the expected water rights.

## Legal Principles

- When property is acquired for a lump sum and later disposed of in parts, Treas. Reg. § 1.61-6(a) requires the taxpayer’s original cost basis to be apportioned among the component interests to compute gain or loss on each disposition.
- A “component interest” may include economically valuable, realistically expected future rights associated with property at the time of purchase, even if not legally vested at that moment.
- Treating later-realized rights as having a zero basis is improper where the purchase price included value attributable to the expectation of those rights, because it overstates gain on the rights and leaves an overstated basis in the retained property.
- The existence and amount of allocable basis are fact questions; the taxpayer must support a reasonable allocation using evidence of value at the time of acquisition.

## Conclusion

The Ninth Circuit held that a lump-sum land purchase basis can be allocated to later-sold irrigation water rights when the land’s purchase price reflected a realistic, economically significant expectation of obtaining those rights, and it remanded for fact-finding on the proper allocation.


Gladden v. Commissioner, 262 F.3d 851 (9th Cir. 2001)