Ninth Circuit allows basis allocation to expected property rights.

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 were a capital asset, but did not decide the Sec. 1231 issue. It then ruled that none of the land's basis could be allocated to the water rights because they were not vested when SMR purchased the land. Therefore, the water rights were acquired in a separate transaction at a zero basis. The court concluded that after SMR sold the water rights, it owned the same interest in the land (and had the same basis in that interest) that it purchased in 1976.

Rejecting the "vested" standard, the Ninth Circuit reversed the Tax Court's refusal to allocate any of the land's basis to the water rights. Instead, the court ruled that an allocation should be made because, when SMR purchased the land, it paid a premium for the "realistic expectation that water rights would eventually attach to the land." That expectation had "real economic value" when the premium was paid. The Tax Court's analysis would erroneously treat this situation the same as the purchase of similar land at a lower price when the purchaser had virtually no expectation of receiving water rights.

The Ninth Circuit cited Piper, 5 TC 110 (1945), in which the Tax Court ruled that a taxpayer who acquired common stock and warrants in the same transaction could allocate some of his basis to the later-exercised warrants on selling some of the stock. The warrants had value when acquired, even though they could not be exercised at a gain at that time and were highly speculative.

The Ninth Circuit also cited Rev. Rul. 86-24, in which a farmer paid $250x for cows artificially impregnated with transplanted embryos. Their market value before impregnation was $80x. After the cows gave birth, the farmer sold the cows for $80x and kept the calves. The Service ruled that the farmer recognized no gain or loss on the sale of the cows, and had $170x basis in the embryos, which became the basis of the calves.

The Ninth Circuit presented an example of how the Tax Court's ruling would lead to erroneous results. Consider two parcels of land: Greenacre, almost certain to receive water rights, is purchased for $1,000, and Brownacre, without this expectation, is purchased for $500. Greenacre subsequently receives the water rights and sells them for $500. The following year, Greenacre is sold for $500. Under the Tax Court's approach, there is a $500 gain on the water rights sale, and a $500 loss on the land sale "when in fact neither occurred." The Ninth Circuit would record no gain or loss on either sale, because the water rights and the land would each have a $500 basis.

The Ninth Circuit also ruled that the amount of the land's purchase price to be allocated to the water rights is the premium paid for the expectation of the water rights when the land was purchased. This could be determined by comparing the price of SMR's land purchase to the purchase of similar land without any expectation of water rights. The Ninth Circuit remanded the case to the Tax Court either to make this determination or to decide that determining the premium is impractical or impossible.

To benefit from Gladden, taxpayers will be required to prove that, on purchasing property, they paid a premium for the realistic expectation that they would receive additional property in the future. Knowing similar property's price without this expectation would be the best evidence of the premium's value.

FROM PETER C. BARTON, MBA, CPA, J.D., PROFESSOR OF ACCOUNTING, AND CLAYTON R. SAGER, PH.D., ASSOCIATE PROFESSOR OF ACCOUNTING, UNIVERSITY OF WISCONSIN-WHITEWATER, WHITEWATER, WI (NEITHER ASSOCIATED WITH AFAI)