Taxpayers Can Treat the Premium Paid for Expected Property Rights as the Cost Basis of the Later-Acquired Rights: Gladden v. Commissioner
In Gladden v. Commissioner, the Court of Appeals for the Ninth Circuit held that when “a purchaser pays a premium for land based on a realistic expectation that water rights will attach to that land in the future, the purchaser may, upon sale of the later-acquired water rights, claim a cost basis [in such rights] equal to the premium paid.” The Ninth Circuit reversed and remanded the case to the Tax Court to determine what premium, if any, had been paid for the expected water rights. The Ninth Circuit’s holding that apportionment of the land’s cost basis might be possible reflects two important points. First, the Ninth Circuit rejected the Commissioner’s bright-line rule, adopted by the Tax Court, which prohibited apportionment of the cost basis in land to the sale of appurtenant water rights not fully vested in the land at the time of the purchase. Second, the Ninth Circuit also rejected the bright-line rule suggested by the taxpayer. The taxpayer argued that it was impossible or impractical to apportion a definite basis to the water rights. Therefore, the taxpayer argued that it would be appropriate to recover the entire cost basis in the land before reporting any capital gain from a sale of the land or any rights in the land. The Ninth Circuit’s decision is significant because it reaffirms the general apportionment rule requiring allocation of cost basis among the several property rights acquired in a lump-sum purchase but disposed of later in several units. The Ninth Circuit’s application of the general apportionment rule demands that practitioners and taxpayers carefully allocate some basis to the particular property right sold in order to survive Service scrutiny and Tax Court review. This is especially true in the context of risk-laden, high-yield capital assets such as the expected water rights at issue in the Gladden cases. Furthermore, by rejecting the taxpayer’s argument, the court narrowly construed an exception to the general apportionment rule, set forth in Inaja Land Co. v. Commissioner, that was formulated to address difficult to value property rights. The exception allows a taxpayer to exhaust his entire cost basis in property before having to recognize any gain when apportionment of basis to the particular property right sold is “wholly impractical or impossible.”Part I of this Note sets forth the factual background of the Gladden cases. Part II summarizes the holdings of the Tax Court and of the Ninth Circuit. Part III sets out the tax policy issues presented in the Gladden cases and analyzes the Ninth Circuit’s decision that expected water rights had some value at the time of the initial land purchase and that the premium paid for the rights should be available to offset the sale proceeds received in exchange for the water rights. Part IV concludes that the Ninth Circuit correctly decided the tax issues, but failed to explain its holding so as to provide concrete guidance to practitioners, taxpayers, and subsequent courts.