Day v. Comm'r of Internal Revenue
| Decision Date | 25 June 1970 |
| Docket Number | Docket Nos. 3968-68,3978-68. |
| Citation | 54 T.C. 1417 |
| Parties | DON C. DAY AND CATHERINE DAY, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENTDAN DAY AND ROBERTA DAY, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Clarence P. Brazill, Jr., for the petitioners.
John W. Dierker, for the respondent.
Petitioners received lump-sum cash payments in consideration of their executing agreements conveying, for a period of 25 years renewable for an additional 20 years, the rights to all of the water underlying their lands. The aquifer containing the water is not subject to recharge, and the purchaser could, and intended to, extract all the water. Held, petitioners did not retain an economic interest in the water in place, the agreements effected sales rather than leases, and the consideration received by petitioners is taxable as capital gain rather than ordinary income.
In these consolidated cases respondent determined deficiencies in petitioners' income tax for 1965 as follows:
+----------------------------------------------------+
¦Docket No. ¦Petitioners ¦Amount ¦
+------------+----------------------------+----------¦
¦ ¦ ¦ ¦
+------------+----------------------------+----------¦
¦3968-68 ¦Don C. Day and Catherine Day¦$13,329.90¦
+------------+----------------------------+----------¦
¦3978-68 ¦Dan Day and Roberta Day ¦13,868.05 ¦
+----------------------------------------------------+
The only issue presented for decision is whether the consideration received by petitioners upon their conveyances of water rights to Pan American Petroleum Corp. constituted ordinary income or capital gain.
At the time their petitions were filed Don C. and Catherine Day, husband and wife, and Dan and Roberta Day, also husband and wife, were legal residents of Meadow, Tex. Both couples timely filed their respective joint income tax returns for 1965 with the district director of internal revenue, Dallas, Tex. Don and Dan will hereinafter be referred to as petitioners.
During 1965 petitioners were engaged in the ranching and farming business and kept their records and filed their income tax returns on a cash basis.
Petitioners' farm properties are located in the Southern High Plains, an area of Texas and New Mexico south of the Canadian River and east of the Pecos River. It is a plateau, covering approximately 35,000 square miles (approximately 22 million acres), which stands high above the surrounding countryside.
Within the Southern High Plains plateau is a geological formation known as the Ogallala,1 which contains underground water, termed by hydrologists as ‘ground water,‘ in significant quantities. The Ogallala formation, ranging in thickness from a few feet to several hundred feet, consists of interbedded layers of various materials, some of which are water-bearing, i.e., the void spaces between the particles of material contain water. The layers of materials are permeable in the sense that water can move through them. In general, both the bottom of the Ogallala formation and the land surface in the Southern High Plains slope from northwest to southeast at an average rate of about 10 feet per mile.
Over a long period of time, during the Pliocene age (from 1 to 10 million years ago), streams flowing generally from the Rocky Mountains, from the west toward the east, deposited the materials which make up the Ogallala formation. Thereafter, part of the Ogallala formation was eroded away; the Canadian River carved out a valley to the north and the Pecos River turned south and carved out a valley to the west, thus creating the northern and western boundaries of the Ogallala formation. The eastern and southern boundaries of the Ogallala are, respectively, an escarpment (a steep cliff) similar to those cut by the Canadian River and Pecos River, and older formations which lie at a lower elevation. These boundaries distinctly separate the Ogallala from the surrounding countryside.
Underlying the entire Ogallala formation are rocks, referred to as ‘red beds,’ which were deposited in the Triassic and Permian geological time periods. The red beds range in thickness to several thousand feet and are relatively impermeable, thus forming a basin for the water in the Ogallala formation, as a consequence the water does not percolate downward to any appreciable degree. The geological formation below the Ogallala are, in general, non-water-bearing or contain only limited supplies of fresh or salty water.
Because the bottom of the Ogallala formation consists of the impermeable red beds and is above the surrounding countryside, the only source from which new water of any kind can move into the Ogallala formation is seepage from precipitation on the surface of the ground.
Precipitation in the Southern High Plains is irregular from year to year. It averaged approximately 20 inches annually between 1890 and 1968. This water is dissipated in one of four ways: (1) Evaporation, (2) transpiration (absorption by plants), (3) runoff, and (4) seepage downward (water thus entering the underground reservoir is known as recharge). More than 99 percent of the average annual rainfall is evaporated or absorbed by plants, and there is only a negligible amount of stream runoff from the surface. During periods of heavy precipitation, water collects in thousands of playa lakes, which are dry most of the time, dotting the Southern High Plains. Perhaps 90 percent of the water that collects in the playa lakes evaporates; the remainder eventually reaches the Ogallala ground water reservoir as recharge. The depth from the surface of the Southern High Plains to the water table— i.e., the top of the reservoir— ranges from less than 50 feet to more than 250 feet.
The Ogallala ground water reservoir is a water table aquifer, in which the water level in wells stands at the general level of the water table throughout the aquifer. Ground water in the saturated section of the reservoir responds to gravity and moves through the interstices of the permeable material away from areas of high pressure (recharge areas) and in the direction of areas of low pressure (discharge areas). The water moves from northwest to southeast at the rate of 60 to 200 feet per year.
Under natural conditions (prior to pumping) the Ogallala formation is in a state of dynamic equilibrium, i.e., the average annual natural recharge is approximately equal to the average annual natural discharge. The annual recharge varies from year to year, depending on the amount of rainfall; including all of the wet and dry years, the average annual natural recharge and discharge have approximated 3/20 to 1/2 inch in amount.
Withdrawal of water from the formation by pumping results is no increase in natural recharge and only a negligible decrease in natural discharge. The number of wells pumping water from the Ogallala reservoir has increased from 620 in 1934 to 8,000 in 1948 and 47,000 in 1958. More than 5 million acre-feet were pumped in 1960. Except for isolated variations in a few individual wells, from 1938 to 1969 there has been an increasing, substantial, and generally uniform decline in the water table in the Ogallala reservoir. The decline in the water table is almost in direct proportion to the increase in wells— the more concentrated the wells in an area, the greater the decline in the water table. Between 1958 and 1962 the amount of recoverable water in the entire Ogallala formation declined from 220 million acre-feet to 210 million acre-feet. Ground water in the Ogallala reservoir is in general, and under petitioners' lands in particular, a nonrenewable resource. If present pumping practices continue and if economic considerations do not intervene, the Ogallala reservoir will be exhausted (i.e., the water table will decline to such a point that no well will be able to pump water).
For more than 6 months prior to November 5, 1965, Don and Catherine owned section 35, block D-11, S. K. & K. Survey, Terry County, Tex., and Dan and Roberta owned section 5, block D-14, C. & M. R. R. Co. Survey, in the same county. Pan American Petroleum Corp. (hereinafter Pan American) was the operator of an oil field known as the Prentice Northeast Unit, located in Terry County, and needed water for use in waterflooding /2 its wells. On November 5, 1965, each of the Day couples entered into a contract entitled ‘Conveyance of Water Rights and Agreement’ with Pan American in consideration of $56,000. The contract executed by Don and Catherine— differing from the contract executed by Dan and Roberta only in the description of the property involved— provides in pertinent part as follows:
THAT, we, the undersigned surface, water, and water rights owners, hereinafter referred to as ‘Grantors', for and in consideration of the sum of Ten Dollars ($10.00), and other good and valuable considerations, the receipt and sufficiency of which are hereby acknowledged, have granted, bargained, sold, and conveyed, and by these presents do grant, bargain, sell, and convey unto Pan American Petroleum Corporation, in its capacity as Operator of the Prentice Northeast Unit, in Terry County, Texas, its successors and assigns, hereinafter referred to as ‘Grantee’, for a term of twenty-five (25) years from the date hereof, with the option of renewal for an additional period of twenty (20) years in the manner hereinafter provided, all of the water and water rights in, to, and under, and that may be produced from the following described land in Terry County, Texas, to-wit:
All of the SE/4 Section 35, Block D-11 SK&K Survey, together with the full use of the premises, for the purpose of exploring and drilling for, and producing water therefrom, including the right to install, maintain, operate and remove pumps, pumping equipment, power and other transmission lines, tanks and basins,...
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