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Water, Cost Depletion, and the Federal Tax Code

By Nicholas Orr*

Abrahm Lustgarten’s article for ProPublica, “Gimme A Break! IRS Tax Loophole Can Reward Excessive Water Use in Drought-stricken West,” suggests that the IRS may expand the availability of Revenue Rules 65-269 and 82-214, obscure tax provisions that entitles water-users on Ogallala Formation to a cost depletion deduction.[i] The expansion of the provisions has potentially dire consequences for California’s water crisis because water-users would receive an ever-greater tax deduction as they depleted their groundwater.[ii] However, an examination of the case that created Rule 65-269, and its successor 82-214, suggests that the holding is confined by the unique geology of the Ogallala Formation and doctrine of California’s water law.

The unique geologic formation that underpins the precedent established in United States v. Shurbet, which formed the basis for Revenue Rule 65-269 and 82-214, limits the ability to extend the cost depletion provision to California.[iii] Shurbet arose out of a legal challenge brought by Marvin and Mildred Shurbet against the I.R.S as to whether the couple was entitled to a cost depletion deduction under Sec. 611 of the 1954 Code for their farm in the Southern High Plains region of Texas.[iv] Sec 611 provides, “in the case of mines, oil and gas wells, other natural deposits, and timber, there shall be allowed as a deduction in computing taxable income a reasonable allowance for depletion and for depreciation of improvements.”[v] The Shurbets, reasoning that their water was a finite resource, wanted it treated like Texas’ other great resource, oil.[vi]

The combination of three main geological features of the Ogallala Formation necessarily narrows the holding in Shurbet.[vii] First, the region is incredibly flat: “[b]oth the land surface and the bottom of the Ogallala formation in the Southern High Plains slope from northwest to southeast at an average rate of about 10 feet per mile.”[viii] This means that water to replenish the aquifer is almost entirely based on the region’s precipitation.[ix] Second, although precipitation varies from region to region, because of the combination of “low rainfall, high evaporation, and low permeability of the surface material” natural recharge is far outweighed by withdrawals.[x] Third, and finally, the entire Ogallala aquifer sits upon a bed of impermeable red clay, several thousand feet thick. [xi] This impermeable bottom prevents water from percolating downward, creating a readily measureable and easily accessible water source.[xii] Together, theses features mean the water is an exhaustible resource with very little subterranean flow. Therefore, in Shurbet, the court held because “[i]n Texas the common law rule prevails that the owner of the land owns the soil and the percolating water which is a part of the soil….water in the Ogallala formation is vested in the owners of the land.”[xiii] However, because California lacks analogous geologic formations, and has a different construction of water law, the cost depletion deduction will likely not extend to the state’s water-users.

California’s water laws will likely limit the extension of Rule of 65-269 and 82-214. Texas water law follows the English common law whereby owners own “the ground water if it is not a part of a subterranean stream or underflow of a river.”[xiv] California, in contrast, follows the correlative-rights rule, which gives owners the reasonable use of water underlying their land.[xv] However, in California, water-users are limited by the average safe annual yield, which is equal to the average replenishment rate of the aquifer from natural and artificial sources.[xvi]  In Shurbet, the court ruled that under the English common law and appropriation doctrines, cost depletion is available should the underlying aquifer meet the requisite geologic preconditions.[xvii] However, because California uses average safe annual yield, in a situation where there is little to no yearly recharge, it follows that there should not be a safe annual yield, and thus no water withdrawal.

As Lustgarten’s article shows, the cost depletion rule created by Shurbet creates a perverse incentive for water-users drawing from the Ogallala Formation.[xviii] However, the narrow holding in Shurbet and the differing water law between California and Texas suggests the provisions cannot be widely adopted. Indeed, in Nesmith v. Commissioner, the court declined to extend the Shurbet ruling to the Pecos Aquifer in West Texas because under the region’s geologic conditions, water was an exhaustible resource.[xix] Thus, though water in California will remain a contested issue, under the Shurbet rule, water-users will not be entitled to a cost depletion deduction.

*Nicholas Orr is a Junior Editor on MJEAL. He can be reached at

The views and opinions expressed in this blog are those of the authors only and do not reflect the official policy or position of the Michigan Journal of Environmental and Administrative Law or the University of Michigan.
[i] Abrahm Lustgarten, Gimme a Break! IRS Tax Loophole Can Reward Excessive Water Use in Drought-stricken West, ProPublica (Aug. 17, 2016),

[ii] Lustgarten, supra note 1; I.R.S., Pub. 535, Depletion (2016).

[iii] Edgar S. Bagley, The Ground-Water Depletion Allowance under the Federal Income Tax, 12 Nat. Res. J. 445, 446 (1972).

[iv] Id. at 445.

[v] I.R.C § 611 (West).

[vi] See United States v. Shurbet, 347 F.2d 103, 104 (5th Cir. 1965).

[vii] Id. at 109.

[viii] Id. at 103.

[ix] Bagley, supra note 6, at 446.

[x] Id.

[xi] Shurbet, 347 F.2d 103, 103 (5th Cir. 1965).

[xii] Id.

[xiii] Id. at 106.

[xiv] Id. at 447.

[xv] Id. at 450.

[xvi] Sho Sato, Ground Water Right and Depletion Deduction, 6 Nat. Res. J. 237, 238 (1966).

[xvii] Id. at 447.

[xviii] Lustgarten, supra note 1.

[xix] Karin B. Littlejohn, Tax Ramifications of the Ownership of Natural Resources by Farmers, 29 S.D. L. Rev. 258, 260 (1984); Nesmith v. Comm’r, 31 T.C.M. (CCH) 128 (1972).

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