1031 Exchanges Involving Water Rights (Riparian Water Rights)
When it comes to real estate transactions, water rights can represent a significant portion of a property’s overall value. In certain regions of the United States, especially in the West, water access is as important as the land itself. Investors who own property with associated water rights may wonder whether those rights qualify for a 1031 exchange. The answer depends on how the IRS views water rights under the rules of like-kind property exchanges.
What Are Water Rights?
Water rights grant the legal authority to use water from a particular source, such as a river, lake, or groundwater. These rights vary by jurisdiction, but they typically fall into two broad categories:
Riparian rights – Attached to land adjacent to a body of water, granting the landowner reasonable use of that water.
Appropriative rights – Often independent of land ownership, allowing the right holder to divert and use water elsewhere.
For 1031 exchange purposes, it is critical to determine whether water rights are considered real property under state law.
IRS Treatment of Water Rights in 1031 Exchanges
The IRS generally allows real property to be exchanged for other real property in a 1031 exchange. However, intangible assets or rights that do not meet the definition of real estate may not qualify.
If water rights are tied to land (riparian rights): They are typically considered real property and therefore may qualify as like-kind to other real estate.
If water rights are separate from land ownership (appropriative rights): Their eligibility depends on state law. Some states treat long-term water rights (often 30+ years) as equivalent to real property, while short-term or contractual rights may be considered personal property, which would not qualify.
Like-Kind Standard
In a 1031 exchange, the key requirement is that both relinquished and replacement property must be like-kind. For water rights, this means:
Land with riparian water rights can usually be exchanged for other real property (farmland, ranchland, commercial property, etc.).
Standalone water rights may be exchanged only for other real property interests if state law recognizes them as such.
Short-term or limited-use rights do not meet the like-kind requirement.
Practical Considerations
State Law Governs Classification
Since the IRS looks to state law to determine whether water rights are real property, it is essential to verify classification in the specific jurisdiction where the rights are held.
Duration of Rights
The length of time the rights are held is a factor. Rights with indefinite or perpetual duration are more likely to be considered real property.
Documentation
Investors must provide clear documentation showing that the rights are recognized as real estate and part of the property exchange.
Qualified Intermediary (QI) Role
As with any 1031 exchange, proceeds must be held by a QI, and IRS timelines (45-day identification and 180-day completion periods) still apply.
Example
An investor owns farmland with riparian rights in Colorado. They sell the property and use a 1031 exchange to purchase ranchland in Wyoming. Since both properties involve real estate and the riparian rights are tied to land, the exchange qualifies.
By contrast, if the investor sold only water rights with a short-term appropriation contract, those rights may not qualify as like-kind real estate, making a 1031 exchange unavailable.
1031 exchanges involving water rights can be complex, but in many cases, riparian rights and long-term appropriative rights are considered real property and thus eligible for tax-deferred treatment. The outcome depends heavily on state law and the specific nature of the rights being transferred.
Investors considering such an exchange should carefully review how water rights are classified in their jurisdiction and ensure compliance with IRS like-kind standards.
