UNITED STATES TAX COURT



    WILLIAM T. GLADDEN AND NICOLE L. GLADDEN, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 16932-97.                 Filed April 15, 1999.



          On cross-motions for partial summary judgment,
     held, partnership water rights constitute capital
     assets. Held, further, no portion of partnership's tax
     basis in land the partnership acquired in 1976 is to be
     allocated to the water rights the partnership acquired
     in 1983 and relinquished in 1992.



     William Louis Raby, Burgess J. William Raby, and

 James J. Rossie, Jr., for petitioners.

     Katherine Holmes Ankeny, for respondent.


                                OPINION

     SWIFT, Judge:   This matter is before us on the parties'

motions and cross-motions for partial summary judgment.
                              - 2 -


     In 1993, as investors in a partnership named Saddle Mountain

Ranch which owned land in Harquahala Valley, Arizona (the

partnership), petitioners received a portion of $28.7 million

paid by the Federal Government to certain Harquahala Valley

landowners in connection with the landowners' relinquishment of

the right each year to receive Colorado River water to irrigate

their land (water rights).

     Initially, the parties cross-move for partial summary

judgment on the issue as to whether the partnership’s water

rights constitute capital assets.   Respondent would treat the

partnership's water rights as not rising to the level of capital

assets.

     If, as a matter of partial summary judgment, we conclude

that petitioners' water rights do constitute capital assets, then

the parties cross-move for partial summary judgment on the issue

as to whether the funds should be regarded as having been

received in a sale or exchange for the water rights so as to

qualify the funds received as capital gain income.

     If each of the above issues is resolved in favor of

petitioners, the parties cross-move for partial summary judgment

on the issue as to whether any of the partnership's approximate

$675,000 tax basis in its ownership interest in Harquahala Valley

land is allocable to and would offset funds received for the

water rights.

     If each of the above issues is resolved in favor of

petitioners, petitioners then move for partial summary judgment
                               - 3 -


on the issue as to how much of the partnership's tax basis in the

land is allocable to the water rights.   Petitioners contend that

it would be impossible to allocate any specific portion of the

partnership's tax basis in the land to the partnership's water

rights, and petitioners therefore contend that the partnership's

total tax basis of approximately $675,000 in the land should be

allocated to the water rights and should offset the funds the

partnership received.   Respondent objects to partial summary

judgment on this issue on the grounds that material facts remain

in dispute as to what portion of the partnership's tax basis in

the land should be allocated to the water rights.

     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the year in issue.

     Set forth below are the facts relating to the above issues.

     When the petition was filed, petitioners resided in Buckeye,

Arizona.

     In 1928, the Boulder Canyon Project Act, ch. 42, 45 Stat.

1057 (1928), was enacted.   This statute relates to use and

allocation of lower Colorado River water and is the statute under

which the water rights at issue in this case were granted.

     In 1963, the Supreme Court decided Arizona v. California,

(1963), and concluded therein, among other things,

that the Boulder Canyon Project Act preempted State

administration of lower Colorado River water and that under the

Boulder Canyon Project Act and administrative rulings of the U.S.
                                - 4 -


Department of the Interior (Interior Department), Arizona, each

year, had claim to 2.8 million acre-feet of Colorado River water.

     In 1964, under Ariz. Rev. Stat. Ann. sec. 48-2901 (West

1997), the Harquahala Valley Irrigation District (HID) was formed

as an Arizona municipal corporation or political subdivision, and

not as a taxable corporation, for the purpose of establishing a

local water distribution system in and about Harquahala Valley,

Arizona.    With regard specifically to water irrigation districts,

under Ariz. Rev. Stat. Ann. sec. 48-2978 (West 1997), it is

provided, among other things, that irrigation districts may

purchase or acquire water rights, construct, acquire, and

purchase canals, ditches, and reservoirs, and distribute water

for irrigation purposes.

     In 1968, pursuant to the Boulder Canyon Project Act and

apparently as a followup to the Supreme Court’s decision in

Arizona v. 

, the Colorado River Basin Project

Act (CRBPA), Pub. L. 90-537, 82 Stat. 885 (1968), was enacted,

which authorized construction by the Federal Government of the

Central Arizona Project (CAP), a system of aqueducts and related

facilities for distribution of lower Colorado River water

throughout Central Arizona.    Under this statute, Colorado River

water that would become available for irrigation of land in

Arizona through the CAP distribution system generally was to be

made available only to land that had a “recent irrigation

history”.    CRBPA sec. 304, 82 Stat. 891.
                               - 5 -


     In 1971, under Arizona State law, the Central Arizona Water

Conservation District (CAP Water District) was formed as a

special water conservation district responsible for operation and

maintenance of CAP and for repayment to the Interior Department

of construction costs that the Federal Government would incur for

construction of the CAP water distribution system.

     In 1976, petitioners and other investors formed the Saddle

Mountain Ranch partnership (the partnership), and for a cost of

approximately $675,000, the partnership acquired an ownership

interest in farmland in Harquahala Valley, Maricopa County,

Arizona.

     On February 10, 1983, the Interior Department allocated to

Indian communities, to municipalities and industrial users, and

to non-Indian agricultural users including irrigation districts

such as HID, rights each year to receive, through the CAP

distribution system, up to a specified quantity of Colorado River

water.   Notice of Final Decision, 48 Fed. Reg. 12446 (Mar. 24,

1983).   Under this allocation, HID was granted the right to

obtain Colorado River water for redistribution to Harquahala

Valley landowners for the purpose of irrigating farmland located

within geographic boundaries of the HID water district.

     As set forth in the following schedule, the specific

quantity of lower Colorado River water to which HID was entitled

for the above purpose was 7.67 percent of non-Indian agricultural

lower Colorado River water that was available each year:
                                    - 6 -



      Annual Allocation (in Acre-feet) of Available CAP Water

                                                          Percentage of
                                                            Non-Indian
    To         To Municipal and        To Non-Indian     Agricultural Use
Indian Use      Industrial Use       Agricultural Use    Allocated to HID

309,828            640,000                  Balance              7.67


          On November 18, 1983, a water service subcontract relating

   to distribution of Colorado River water was entered into between

   the Interior Department and the CAP Water District, on the one

   hand, and HID, on the other hand (the Subcontract).    The

   Harquahala Valley landowners were not parties to the Subcontract.

   The Subcontract provides for the delivery over the course of 50

   years by the CAP Water District to HID of the designated quantity

   of available Colorado River water.

          Although Harquahala Valley landowners were not named parties

   to the Subcontract, the terms of the Subcontract were subject to

   approval by Harquahala Valley landowners, and only owners of the

   specified 33,251 acres of "eligible land" referred to in the

   Subcontract were entitled to receive an allocation of Colorado

   River water from HID.     The partnership’s land qualified as part

   of the eligible acres, and thus under the Subcontract, the

   partnership was entitled to receive each year from HID a

   specified quantity of available Colorado River water.

          Under the Subcontract and Arizona law, each year the

   available Colorado River water that was allocated through the CAP

   Water District to HID and that HID elected to receive from the
                                - 7 -


CAP Water District was required to be distributed by HID to the

Harquahala Valley landowners on a per-acre basis.   See Ariz. Rev.

Stat. Ann. sec. 48-2990 (West 1997).

     The Subcontract does not state that the water rights of

Harquahala Valley landowners such as the partnership were

appurtenant to the land.

     Before the beginning of each year, the CAP Water District

would notify HID of the amount of Colorado River water that,

under the Subcontract, would be available to HID during the

following year, and HID would submit to the CAP Water District a

requested monthly water distribution schedule for the following

year indicating how much of the available Colorado River water it

wished to receive.

     Under the Subcontract, HID was required to pay $2 per acre-

foot for Colorado River water it received under the above

allocation and Subcontract.   Over the course of the 50-year term

of the Subcontract, the rate of $2 per acre-foot of Colorado

River water received was subject to periodic review and

adjustment.

     Also under the Subcontract, HID was obligated to pay its

share of annual operating and maintenance costs of the CAP Water

District distribution system.

     As Harquahala Valley landowners entitled to and receiving

Colorado River water from HID, the landowners, including the

partnership herein, were required each year to pay HID for the

Colorado River water they received under the above allocation and
                              - 8 -


Subcontract, at a rate, with certain adjustments, per acre-foot

of water pegged to what HID was required to pay the CAP Water

District.

     Each year, HID, with approval of the CAP Water District

could sell or exchange “excess” water (namely, Colorado River

water available under the Subcontract that the Harquahala Valley

landowners did not wish to receive) but only to landowners within

Maricopa, Pinal, and Pima Counties, Arizona.   Funds HID realized

on sale of excess water, over and above its costs, could not be

retained by HID but were required to be paid to the CAP Water

District to pay down the debt obligation of HID to the CAP Water

District.

     The Harquahala Valley landowners could sell their beneficial

interests in Colorado River water rights to third parties but

only as part of a sale of their ownership interests in the land.

     Under the Subcontract, it was provided that all uses of

Colorado River water by water districts and landowners to whom

the water was allocated and distributed had to be consistent with

Federal Government and CAP Water District directives regarding

Colorado River water.

     Under the Subcontract, the Interior Department retained the

right to sell to other water districts, to landowners, and to

others Colorado River water that was not distributed to those

with specific allocations under the Subcontract.

     In 1984, HID contracted with the Interior Department for

construction of a water distribution system in and about
                               - 9 -


Harquahala Valley, Arizona (local water distribution system),

that would connect with the CAP Colorado River water distribution

system.   HID issued $8.4 million in municipal bonds to raise

funds to reimburse the Interior Department for a portion of

construction costs the Interior Department had advanced for

construction of the local water distribution system.

     During 1983 through July of 1992, HID and the Harquahala

Valley landowners received annual distributions of Colorado River

water under the Subcontract.

     On July 17, 1992, HID sent a written notice to the

Harquahala Valley landowners of a special election regarding

relinquishment of HID’s water rights under the Subcontract.     The

notice explained that HID’s proposed relinquishment of water

rights would occur in exchange for payment by the Federal

Government to HID of HID’s debt and bond obligations to the

Federal Government and for the payment of other funds.    The

notice further explained that funds HID would have available as a

result of the payment for relinquishment of its water rights,

after expenses and debts, could be distributed to the Harquahala

Valley landowners.

     On August 7, 1992, HID and the Federal Government signed an

agreement in principle under which HID agreed to relinquish up to

100 percent of its Colorado River water rights, and the value of

the water rights to be relinquished was agreed to be $1,050 per

acre-foot of water.
                              - 10 -


     On August 11, 1992, the Harquahala Valley landowners,

including the partnership, held an election in which they

approved relinquishment by HID of the Colorado River water rights

under the Subcontract.

     On December 1, 1992, a final agreement (Master Agreement)

was entered into between the Interior Department and HID for

relinquishment or termination of HID’s water rights under the

Subcontract.   Thereunder, HID relinquished to the Interior

Department its rights under the above 1983 water supply

Subcontract to receive over the course of the next 40 or more

years Colorado River water, and the Interior Department agreed to

discharge HID's debt to the Federal Government in relation to the

construction of the local water distribution system and to pay

HID $28.7 million.

     The Master Agreement acknowledged that the terms and

conditions under which HID relinquished its Colorado River water

rights were approved by the Harquahala Valley landowners.

     The Master Agreement provided that, in entering into the

agreement, HID was acting in its capacity as a municipal

corporation of the State of Arizona and that there existed no

third-party beneficiaries to the Agreement.

     Under the July 17, 1992, notice to the landowners and under

the Master Agreement, landowners who did not agree to

relinquishment of their water rights had the option to continue

to receive Colorado River water under the 1983 Subcontract.
                             - 11 -


Thus, if petitioners' partnership or if any of the other

Harquahala Valley landowners had not agreed to relinquishment of

the water rights, HID could not have disposed of the water rights

relating to the land of the objecting landowners.

     Apparently, one Harquahala Valley landowner voted against

relinquishment of the water rights, but the record does not

disclose the subsequent history of that landowner and its receipt

of Colorado River water.

     In late 1992, in exchange for relinquishment of its Colorado

River water rights, HID received $28.7 million from the Interior

Department.

     On January 5, 1993, HID's board of directors met and

authorized distribution of $24.6 million to the Harquahala Valley

landowners who had approved relinquishment of the water rights.

As part of the distribution that occurred, petitioners'

partnership received $1,088,132.

     Upon receipt of the above funds, each Harquahala Valley

landowner entered into a distribution agreement and release

(Distribution Agreement) with HID under which it was provided

that the landowners would return to HID any “relinquishment

funds” they received if an error in payment occurred or if HID

incurred a liability necessitating the use of the funds.

     There is no express provision in the Distribution Agreement

indicating that the distribution occurred in exchange for any

right of the landowners in Colorado River water.
                               - 12 -


     At the time of the 1992 Master Agreement, the local water

distribution system that was connected to CAP and that was

maintained by HID was complete.    HID agreed to continue to

maintain and operate this water distribution system in subsequent

years, by purchasing water on the open market and distributing

and selling water to the Harquahala Valley landowners and to

others as the landowners and others decided to purchase water

from HID at market rates.    The CAP Water District was one of the

sources from which HID might purchase water in subsequent years,

depending on the price of water available through CAP in

comparison to the price of water available from other sources.

     After relinquishment to the Interior Department of the water

rights by the Harquahala Valley landowners, the water rights were

reallocated to other users of Colorado River water.

     On March 21, 1994, the Inspector General of the Interior

Department issued an audit report regarding the Master Agreement

and relinquishment by HID of its Colorado River water rights.

This report faulted the Interior Department in the negotiations

relating to relinquishment of HID’s water rights and for

discounting the value of HID's debt obligation to the Federal

Government to a present value (as of the end of 1992) of $5.8

million, which was factored into the computation of the payment

to HID of $28.7 million.    This report also stated that the

Harquahala Valley landowners “unduly benefited” by receipt of

$24.6 million in connection with relinquishment of the water

rights.
                              - 13 -


     On June 5, 1995, the U.S. General Accounting Office issued a

report to a congressional committee regarding relinquishment by

HID to the Interior Department of its Harquahala Valley water

rights.   Therein, that transaction is described as a “sale of a

water entitlement” by the Harquahala Valley landowners.


                            Discussion

Capital Asset Treatment of Water Rights

     As explained, petitioners contend, as a matter of law and

partial summary judgment, that the water rights of the

partnership constitute capital assets and that relinquishment

thereof by the partnership constituted a sale or exchange.

Respondent contends, also as a matter of law and partial summary

judgment, that relinquishment by the partnership of water rights

did not constitute a sale or exchange of a capital asset and

therefore that the $1,088,132 the partnership received in 1993

should be treated as ordinary income.

     In order for contract rights to qualify as capital assets

under section 1221, the contract rights must constitute

“property” of the taxpayer and not constitute any of the five

types of property excluded from capital gain treatment under

section 1221(1) through (5) (namely, (1) inventory;

(2) depreciable personal property or real property used in a

trade or business; (3) certain intangible property; (4) accounts
                               - 14 -


receivable acquired in a trade or business; and (5) certain

governmental publications).1


1
     Sec. 1221 provides as follows:

          SEC. 1221.   CAPITAL ASSET DEFINED.

          For purposes of this subtitle, the term “capital asset”
     means property held by the taxpayer (whether or not
     connected with his trade or business), but does not
     include--

               (1) stock in trade of the taxpayer or other
          property of a kind which would properly be included in
          the inventory of the taxpayer if on hand at the close
          of the taxable year, or property held by the taxpayer
          primarily for sale to customers in the ordinary course
          of his trade or business;

               (2) property, used in his trade or business, of a
          character which is subject to the allowance for
          depreciation provided in section 167, or real property
          used in his trade or business;

               (3) a copyright, a literary, musical, or artistic
          composition, a letter or memorandum, or similar
          property, held by--

                    (A) a taxpayer whose personal efforts created
               such property,

                    (B) in the case of a letter, memorandum, or
               similar property, a taxpayer for whom such
               property was prepared or produced, or

                    (C) a taxpayer in whose hands the basis of
               such property is determined, for purposes of
               determining gain from a sale or exchange, in whole
               or part by reference to the basis of such property
               in the hands of a taxpayer described in
               subparagraph (A) or (B);

               (4) accounts or notes receivable acquired in the
          ordinary course of trade or business for services
          rendered or from the sale of property described in
          paragraph (1);

               (5) a publication of the United States Government
                                                   (continued...)
                             - 15 -


     Neither party herein suggests that any of the above five

statutory exceptions applies to the water rights in issue.

Petitioners, in their briefs, note that if the water rights in

issue were to be treated as “real property” used in the trade or

business of the partnership's farming activity, and therefore as

excluded from capital asset treatment under section 1221, gain

realized on the sale of the water rights would, in any event, be

treated as capital gain under section 1231.   Neither party,

however, pursues this possible treatment of the partnership's

water rights as section 1231 “real property”.   Thus, the only

question before us is whether the partnership's water rights

constitute “property” and capital assets under section 1221.2




1
 (...continued)
          (including the Congressional Record) which is received
          from the United States Government or any agency
          thereof, other than by purchase at the price at which
          it is offered for sale to the public, and which is held
          by--

                    (A) a taxpayer who so received such
               publication, or

                    (B) a taxpayer in whose hands the basis of
               such publication is determined, for purposes of
               determining gain from a sale or exchange, in whole
               or in part by reference to the basis of such
               publication in the hands of a taxpayer described
               in subparagraph (A).
2
     The fact that the water rights involved herein constitute
surface water rights, rather than in situ water rights, may
explain why petitioners do not argue that the water rights
qualify as “real property” and therefore qualify for capital gain
treatment under sec. 1231.
                              - 16 -


     The policy considerations and rule of construction

concerning what constitutes capital assets have been explained as

follows:


          The preferential treatment afforded by the capital
     gains provisions, 26 U.S.C.A. secs. 1201-1202, 1221-
     1223, was designed “to relieve the taxpayer from * * *
     excessive tax burdens on gains resulting from a
     conversion of capital investment * * *.” Burnet v.
     Harmel, 

, 106, 

, 75, 

. In Commissioner of Internal Revenue v. Gillette
     Motor Transport, Inc., 

, 134, 

, 1500, 

, the Court held that it was
     “the purpose of Congress to afford capital-gains
     treatment only in situations typically involving the
     realization of appreciation in value accrued over a
     substantial period of time, and thus to ameliorate the
     hardship of taxation of the entire gain in one year.”
     Commissioner of Internal Revenue v. P.G. Lake, 

; Burnet v. 

. * * * [Wiseman v.
     Halliburton Oil Well Cementing Co., 

, 658
     (10th Cir. 1962).]


See also Freese v. United States, 

, 1150 (10th Cir.

1972); Elliott v. United States, 

, 1155 (10th Cir.

1970).

     As we have previously explained, see Foy v. Commissioner,

, 65-70 (1985), no single definitive explanation is

available of what types of property qualify as capital assets

under section 1221.

     Over the years, court decisions have recognized limitations

on the types of property which qualify as capital assets under

section 1221.   In Corn Prods. Ref. Co. v. Commissioner, 

, 51 (1955), assets that were an integral part of a taxpayer's

business were held not to qualify as capital assets.   In that
                               - 17 -


case, the Supreme Court held that although corn futures contracts

did not fall expressly within the statutory exclusions, profits

received from the purchase and sale of futures contracts entered

into in order to assure a reasonably priced supply of corn

inventory for the taxpayer's business did not qualify for capital

gain treatment.    The Court observed that “Congress intended that

profits and losses arising from the everyday operation of a

business be considered as ordinary income or loss rather than

capital gain or loss.”    

     In 1988, in Arkansas Best Corp. v. Commissioner, 

, 219 (1988), the Supreme Court clarified that the Corn Prods.

judicial exception is more properly interpreted as involving an

application of the statutory exception for inventory under

section 1221(1).    See also FNMA v. Commissioner, 

,

573 (1993).   As explained, respondent does not contend that

petitioners' contract rights fall within the inventory exception

to capital asset treatment.

     Another limitation on the types of property which qualify

for treatment as capital assets was explained by the Supreme

Court in Commissioner v. P.G. Lake, Inc., 

(1958).

Thereunder, a mere right to receive ordinary income generally

will not qualify as a capital asset.    The issue in Commissioner

v. P.G. Lake, 

, was whether a transfer of royalty

rights associated with the production of oil constituted sale of

a capital asset.    After the transfer, the taxpayer retained a

reversionary interest in the underlying oil and gas leases, and
                              - 18 -


the purchaser acquired nothing more than a right to receive a

portion of the royalties for a limited time.   The Supreme Court

noted that the amount received for the transfer was virtually

equivalent to the amount of royalty income that otherwise would

have been received.   The Supreme Court concluded that the only

right the taxpayer sold was the right to receive ordinary income

and held that the royalty right did not constitute a capital

asset.   The Supreme Court noted as follows:


     The substance of what was assigned was the right to
     receive future income. The substance of what was
     received was the present value of income which the
     recipient would otherwise obtain in the future. In
     short, consideration was paid for the right to receive
     future income, not for an increase in the value of the
     income-producing property. [Id. at 266.]


     Subsequent decisions have attempted to clarify the holding

of the Supreme Court in P.G. Lake, Inc.   With respect to the

broad proposition that amounts received for the transfer of a

right to receive future income will not qualify for capital gain

treatment, the Court of Appeals for the Fifth Circuit in United

States v. Dresser Indus., Inc., 

(5th Cir. 1963),

explained--


     As a legal or economic position, this cannot be so.
     The only commercial value of any property is the
     present worth of future earnings or usefulness. If the
     expectation of earnings of stock rises, the market
     value of the stock may rise; at least a part of this
     increase in price is attributable to the expectation of
     increased income. The value of a vending machine, as
     metal and plastic, is almost nil; its value arises from
     the fact that it will produce income. [Id. at 59.]
                                - 19 -


     In applying the P.G. Lake, Inc. limitation on what property

qualifies as a capital asset, courts generally consider the

entire economics of a transaction, as suggested by Dresser

Indus., Inc. in the above quotation, and evaluate all of the

rights of the taxpayer, as well as all of the risks and

obligations of the taxpayer associated with ownership of the

property before the transfer.    For example, in an attempt to

explain P.G. Lake, Inc., we stated in Guggenheim v. Commissioner,

(1966)--


          The Court in Lake was faced with the problem
     whether a transfer of part of a capital asset is itself
     the transfer of a capital asset. That part was defined
     and delineated by the taxpayer in such a manner as to
     consist essentially of only the rights to income. The
     transferee assumed few of the risks identified with the
     holding of a capital asset; he assumed only a nominal
     risk of his oil payment right decreasing in value and
     none of the possibility of the oil payment right
     increasing in value. On the other hand, the taxpayer,
     after the transfer, retained essentially all of the
     investment risks involved in his greater interest to
     the same extent as before the transfer. [Id. at 569.]


The above statement implies that whether investment risks are

associated with contract rights transferred is a particularly

relevant consideration in determining whether the rights are to

be treated as capital assets.

     In Commissioner v. Ferrer, 

, 130 (2d Cir. 1962),

revg. in part and remanding 

(1961), the Court of

Appeals for the Second Circuit concluded, among other things,

that where a taxpayer's “bundle of rights” reflected “something

more than an opportunity, afforded by contract, to obtain
                                - 20 -


periodic receipts of income,” and where they included “equitable

interests” similar to those of an owner of property, they were to

be treated as capital assets.

       The basic proposition of Commissioner v. P.G. Lake, 

at 265, is still viable.     Where a taxpayer merely

“[substitutes] the right to receive ordinary income from one

source for the right to receive ordinary income from another

[source],” the rights transferred will not be considered a

capital asset.     United States v. Dresser Indus., 

at 59; see also Arkansas Best Corp. v. Commissioner, supra at 217

n.5.

       To summarize, in determining whether a taxpayer's contract

rights that are transferred constitute capital assets, courts

generally consider all aspects of the taxpayer’s bundle of rights

and responsibilities that are transferred, specifically including

the following six factors:


       (1)   How the contract rights originated;

       (2)   How the contract rights were acquired;

       (3) Whether the contract rights represented an equitable
       interest in property which itself constituted a capital
       asset;

       (4) Whether the transfer of contract rights merely
       substituted the source from which the taxpayer otherwise
       would have received ordinary income;

       (5) Whether significant investment risks were associated
       with the contract rights and, if so, whether they were
       included in the transfer; and
                                - 21 -


     (6) Whether the contract rights primarily represented
     compensation for personal services. [Foy v. Commissioner,
     

.]


     Both parties herein rely on certain Supreme Court cases that

involve general, nontax issues regarding water rights.    See

Nevada v. United States, 

(1983); Ickes v. Fox, 

(1937).   At issue in Nevada were rights of landowners to

water from the Truckee River in Nevada.    At issue in Ickes were

rights of landowners to water from the Sunnyside Unit of the

Yakima Project in Washington.    The water rights in both cases

were based on the Reclamation Act, ch. 1093, 32 Stat. 388 (1902).

     In Nevada v. United 

at 126, the Supreme Court

explained that "the beneficial interest in the rights confirmed

to the Government resided in the owners of the land within the

Project to which these water rights became appurtenant upon the

application of Project water to the land," and that "the law of

Nevada, in common with most other western States, requires for

the perfection of a water right for agricultural purposes that

the water must be beneficially used by actual application on the

land."

     In Ickes v. 

at 94-95, the Supreme Court stated:


     Although the government diverted, stored and
     distributed the water, the contention of petitioner
     that thereby ownership of the water or water-rights
     became vested in the United States is not well founded.
     Appropriation was made not for the use of the
     government, but, under the Reclamation Act, for the use
     of the land owners; and by the terms of the law and of
     the contract already referred to, the water-rights
     became the property of the land owners, wholly distinct
                                - 22 -


       from the property right of the government in the
       irrigation works. * * *


       As stated, the water rights and allocations involved in both

Nevada and Ickes were based on the Reclamation Act passed by

Congress in 1902.    Thereunder, it was expressly provided that

"the right to the use of water acquired under the provisions of

this Act shall be appurtenant to the land irrigated, and

beneficial use shall be the basis, the measure, and the limit of

the right."    Ch. 1093, sec. 8, 32 Stat. 390.

       Consistently with the above statutory language, the

underlying contracts involved in Nevada between the U.S.

Government and the landowners provided generally “for a permanent

water right for the irrigation of and to be appurtenant to all of

the irrigable area now or hereafter developed under the [Newlands

Reclamation Project]”.     Nevada v. United 

at 127

n.9.    Similarly, the underlying contracts involved in Ickes

between the U.S. Government and the landowners provided generally

that the “rights shall be, and thereafter continue to be, forever

appurtenant to designated lands owned by such shareholders.”

Ickes v. 

at 89.

       Petitioners argue that the above language from Nevada and

Ickes supports a conclusion that the Harquahala Valley

landowners’ water rights under the Subcontract were appurtenant

to the landowners’ land.

       Respondent relies on the same cases and emphasizes

differences in the relevant Federal law and the underlying
                               - 23 -


contracts that were involved in those cases and in the Boulder

Canyon Project Act that is involved in the instant case.

     We now apply the law, as set forth and discussed above, to

the undisputed facts of this case.      The participation and rights

of the partnership in which petitioners invested in Colorado

River water originated in 1983 only as a result of and in direct

proportion to the partnership’s ownership interest in Harquahala

Valley land.   The 1983 allocation of water rights to HID under

the Subcontract and through HID to the partnership under Arizona

law was directly linked to and dependent upon the partnership’s

ownership of the land and on irrigation of the land in prior

years.

     Ariz. Rev. Stat. Ann. sec. 48-2990, relating to water rights

and irrigation districts, and under which the partnership in 1983

received its Colorado River water rights, provides in part as

follows:   "Subject to the law of priority, all water of the

district available for distribution shall be apportioned to the

lands thereof pro rata".

     The water rights of the partnership were linked to the

partnership’s ownership interest in the land, to its farming

operations and activities on the land, and to its capital

investment in the land.    The water rights, and particularly the

decision in 1992 to relinquish the water rights, affected the

partnership’s farming activity and the investment risks

associated with that farming activity--especially the financial

risks associated with purchasing water on the open market.
                              - 24 -


     From 1983 through 1992, use of the water rights did not

produce for the partnership, in any direct or immediate sense,

ordinary income.   Rather, using water received, land was planted,

fertilized, and irrigated.   Crops grew.   Eventually, crops were

harvested, transported, and sold.   The water rights at issue

simply represent one component of the partnership’s investment in

and operation of its farming activity.

     Certainly, the $1,088,132 the partnership received in 1993

upon relinquishment of the water rights did not represent merely

a substitute for ordinary income the partnership otherwise would

have received.   Rather, it represented payments the partnership

received in exchange for making a shift in one significant aspect

of its farming activity; i.e., a shift in the source of its

irrigation water from the Colorado River at fixed prices to the

market place at market prices.

     The above undisputed facts surrounding the origination,

allocation, and use of the water rights support the conclusion

that the partnership’s water rights should be treated as capital

assets.   We so hold.

     In spite of differences between the language of the

Reclamation Act, involved in Nevada v. United 

, and

Ickes v. 

, and the language of the Boulder Canyon

Project Act, involved in the instant case, we agree generally

with petitioners that such differences in the underlying

statutory language and in the above nontax opinions of the

Supreme Court do not support a conclusion that the water rights
                              - 25 -


involved herein do not constitute capital assets of the

partnership.   To the contrary, as we read the above authority, we

believe they support the conclusion that the water rights

allocated to the partnership for use in its farming activity,

constitute contractual rights that are to be regarded as integral

to the partnership's farming activity (whether technically

appurtenant to the land or not) and as capital assets of the

partnership.

     Respondent acknowledges that the water rights of HID

constitute capital assets.   For purposes of analyzing the capital

asset character of the water rights, we perceive little

difference between HID's rights in Colorado River water and the

allocations the partnership received through the HID in Colorado

River water.   We note, in particular, Ariz. Rev. Stat. Ann. sec.

48-2990, under which water districts must distribute all water

available for distribution "to the lands thereof pro rata”, and

Ariz. Rev. Stat. Ann. sec. 48-2902 (West 1997), under which water

districts are not allowed to divert allocated water from

landowners having a prior right to such water to other purposes

without first compensating the landowners.

     Lastly, we note that respondent's rulings often treat as

capital assets allocations or rights that taxpayers receive from

governmental agencies.   See Rev. Rul. 66-58, 1966-1 C.B. 186

(cotton acreage allotments treated as capital assets); Rev. Rul.

70-644, 1970-2 C.B. 167 (milk allocation rights treated as

capital assets); see also Madera Irrigation Dist. v. Hancock, 985
                             - 26 -


F.2d 1397, 1401 (9th Cir. 1993) (the parties and the Court of

Appeals for the Ninth Circuit treated water rights as property

rights protected by the Fifth Amendment); First Victoria Natl.

Bank v. United States, 

, 1106-1107 (5th Cir. 1980)

(rice production histories and rights to receive allotments of

rice, if and when issued, were treated as property rights

includable in a decedent's gross estate).

     On this issue, we grant petitioners' motion for partial

summary judgment, and we deny respondent's motion for partial

summary judgment.


Sale or Exchange

     If petitioners' water rights in Colorado River water are to

be treated as capital assets, petitioners and respondent cross-

move for partial summary judgment on the issue of whether, for

Federal income tax purposes, relinquishment of the water rights

by the partnership and receipt of $1,088,132 by the partnership

constituted a sale or exchange.   Respondent contends that the

$1,088,132 was transferred to the partnership either for the

partnership’s commitment to indemnify HID for unexpected future

liabilities that might arise or as a mere windfall distribution

to the partnership of HID surplus funds.

     The undisputed evidence establishes that the form and

substance of the transfers of funds that occurred at both levels

(from CAP to HID and from HID to the partnership) were based on

and occurred as a result of the partnership’s relinquishment or
                                - 27 -


exchange of rights to Colorado River water.     Respondent's

contention that the transfer of funds from HID to the partnership

did not constitute a sale or exchange but was based on some

indemnification commitment or windfall distribution of surplus

funds ignores the substance of the transaction by which the

partnership relinquished its water rights in return for the

$1,088,132.

     The mere reference in the 1993 Distribution Agreement to a

boilerplate and routine indemnification commitment and to the

possibility that the landowners might be required to return to

HID some portion of the funds received does not control the

treatment of the transaction.

     The funds were labeled "relinquishment funds”, and that is

what the funds constituted.   The funds were received in exchange

for relinquishment of the water rights.     They were not labeled

and they did not constitute indemnification funds, surplus funds,

or windfall funds.

     Respondent argues that HID was not required to distribute

any of the funds to the partnership.     Assuming arguendo that

respondent is correct, the significant facts are that HID did

distribute those funds to the partnership and that HID did so

only in exchange for relinquishment of the partnership’s water

rights.

     Respondent notes that the partnership and other Harquahala

Valley landowners were not named parties to the Master Agreement,

that under the Master Agreement no third-party beneficiaries were
                             - 28 -


provided for, and that under the Distribution Agreement it was

not expressly provided that relinquishment of the water rights

occurred “in exchange” for the funds distributed.

     Respondent’s arguments are without merit.   The transaction

before us constitutes a sale or exchange by the partnership of

water rights for the $1,088,132 received by the partnership.3

     We grant petitioners' motion for partial summary judgment on

this issue.


Allocation of Partnership’s Tax Basis in Land
to $1,088,132 Partnership Received for Water Rights

     If the above issues are resolved in favor of petitioners, as

they are, petitioners and respondent cross-move for partial

summary judgment on the issue as to whether any portion of the

partnership's $675,000 tax basis in its ownership interest in

Harquahala Valley land is allocable to the water rights and

should be available to offset the $1,088,132 the partnership

received in 1993 upon relinquishment of the water rights.

     Petitioners contend that under the 1983 Subcontract and

under Arizona State law, the partnership’s water rights

constituted part of the bundle of rights represented by land


3
     We note that neither party relies on court opinions
involving so-called vanishing or disappearing assets. See, e.g.,
Nahey v. Commissioner, 

(1998); Towers v.
Commissioner, 

(1955), affd. 

(2d Cir.
1957); Hudson v. Commissioner, 

(1953), affd. per
curiam sub nom. Ogilvie v. Commissioner, 

(6th Cir.
1954). Because the water rights that HID and the partnership
relinquished to the Interior Department reverted to the Interior
Department, survived, and were reallocated to other users, those
opinions would appear inapplicable to the instant controversy.
                             - 29 -


ownership that the partnership held, that the water rights could

be neither bought nor sold separately by the partnership, and

therefore that the partnership's $675,000 cost of purchasing the

land in 1976 should be applied against the $1,088,132 the

partnership received in 1993 on relinquishment of the water

rights.

     Because the water rights were received and sold by the

partnership separately from the land, respondent argues that no

allocation should be allowed of the partnership's land costs to

the funds the partnership received for the water rights.

     For Federal income tax purposes, the general rule provides

that taxpayers recover tax free their cost or tax basis for

property on which gain is to be computed.    See sec. 1001(a).

Section 1016(a)(1) provides in pertinent part that--


     adjustment * * * [to basis shall be made]

          (1) for expenditures, receipts, losses, or other
     items, properly chargeable to capital account * * *


     Petitioners contend that under section 1016, where property

that is sold does not have a separate, identifiable cost or tax

basis and where the property sold is sufficiently integrated with

or appurtenant to related property, the taxpayer’s total cost for

the related property should be charged to the transaction and

only after the taxpayer’s total cost for the related property is

recovered should the taxpayer be required to recognize any

taxable capital gain on the property sold.
                              - 30 -


     More specifically with regard to the facts of this case,

petitioners contend that in 1976 when the partnership acquired

its interest in Harquahala Valley land, the partnership

simultaneously acquired an expectation of future water rights and

that the water rights that were acquired by the partnership in

1983 should be regarded as sufficiently related to or appurtenant

to the land to justify allocating the partnership's 1976 $675,000

cost of purchasing the land to the $1,088,132 the partnership

received in 1993 upon relinquishment of the water rights.

     The facts relevant to this issue are clear, and on this

issue, neither party suggests any material facts in dispute.    In

1976, when it acquired its interest in Harquahala Valley land,

and thereafter until 1983, the partnership did not have vested

property rights in Colorado River water.

     In 1983, the partnership acquired, and in 1992, the

partnership relinquished, Colorado River water rights separately

from any acquisition or sale of its ownership interest in the

land.   Before 1983, the partnership acquired the land without any

vested interest in Colorado River water.   After 1992 (after its

water rights had been relinquished), the partnership owned the

same interest in the same land it acquired in 1976.

     On these facts, no portion of the partnership's original

land acquisition cost or tax basis in the Harquahala Valley land

is properly allocable to the water rights the partnership

received in 1983 and sold or relinquished in 1992.
                                - 31 -


     Petitioners and respondent rely on various cases, Arizona

law, and other authority.     In Inaja Land Co. v. Commissioner,

, 736 (1947), because it was impossible to allocate

with reasonable accuracy a separate cost to easements the

taxpayer sold, the Court allocated the taxpayer's cost of

underlying land to funds received on sale of the easements.     The

taxpayer in Inaja, however, in 1928 had purchased the land not

just with an expectation but with a legal right not to have the

land flooded from unexpected upstream water sources.     In

subsequent years, in connection with construction of a tunnel,

the taxpayer’s land located downstream from the tunnel was

flooded, and the responsible government agency paid the taxpayer

a lump sum for the easement to flood the taxpayer's land.

     In Trunk v. Commissioner, 

, 1139 (1959),

payments received for relinquishment of a right to a possible

condemnation award were treated as received in exchange for a

capital asset.   We also held that because it was impossible or

impracticable to ascertain the taxpayer's specific cost basis for

the right that was relinquished, which was derived from the

taxpayer's right of ownership in the entire property, the

payments received were to be offset by the taxpayer's cost basis

in the entire property.     In the instant case, however, the

partnership's ownership of the land was not acquired with any

vested right to Colorado River water.     Trunk is distinguishable.
                              - 32 -


     The parties refer to Rev. Rul. 66-58, 1966-1 C.B. at 187, in

which the tax treatment of the sale of cotton acreage allotments

was addressed.   In the ruling, it is stated that--


     Where a taxpayer has acquired * * * [a cotton]
     allotment along with the land to which it relates, as a
     unit, the cost or other basis of the entire unit should
     be allocated between the land and the allotment in
     accordance with the relative fair market values of such
     properties on the date of acquisition. * * *


The ruling, however, also explains--


     Of course, no portion of the basis of land, acquired
     prior to the issuance of the cotton allotment, can be
     allocated to such allotment.


     Our discussion of the partnership's water rights in the

context of the above capital asset issue (namely, among other

things, that water rights the partnership received in 1983

related to and were dependent upon the land the partnership

acquired in 1976) is not inconsistent with our analysis and

holding on the instant issue that the water rights were

sufficiently distinct and separate from the partnership's

ownership interest in the land to preclude any allocation of the

partnership's cost or tax basis in the land to the partnership's

water rights.

     The partnership's water rights were related to and dependent

upon the partnership's land ownership, and the partnership's

water rights constituted capital assets of the partnership.    At

the same time, however, as discussed, the partnership's water
                              - 33 -


rights were received in 1983, years after the land was acquired

in 1976, and in a separate transaction.   The partnership then, in

1992, sold the water rights separately from the land and retained

the same land it had acquired in 1976.


Impossibility of Allocation of Portion of Tax Basis in Land

     If the above issues are resolved in favor of petitioners,

petitioners move for partial summary judgment on the issue as to

whether, on the facts of this case, it would be impossible to

allocate a specific portion of the partnership's total cost or

tax basis in its land to the funds the partnership received for

the water rights.   Because of the alleged impossibility of

allocating any specific portion of the partnership's land cost to

the water rights, petitioners, as a matter of summary judgment,

would allocate the partnership's total $675,000 tax basis in the

land to the $1,088,132 the partnership received for the water

rights.

     If we address this issue, respondent objects to partial

summary judgment on the ground that material facts remain in

dispute as to what an appropriate allocation would be of the

partnership’s tax basis in the land to the funds the partnership

received for the water rights.
                             - 34 -


     In light of our conclusion and holding in respondent’s favor

on the prior issue (viz, that no allocation of the partnership’s

cost and basis in the land is to be allocated to the water

rights), we need not address this issue.

      To reflect the foregoing,


                                           An appropriate order

                                   will be issued.