Across many dryland regions, historically grass‐dominated ecosystems have been encroached upon by woody‐plant species. In this paper, we compare ecosystem water and carbon dioxide (CO2) fluxes over a grassland, a grassland–shrubland mosaic, and a fully developed woodland to evaluate potential consequences of woody‐plant encroachment on important ecosystem processes. All three sites were located in the riparian corridor of a river in the southwest US. As such, plants in these ecosystems may have access to moisture at the capillary fringe of the near‐surface water table. Using fluxes measured by eddy covariance in 2003 we found that ecosystem evapotranspiration (ET) and net ecosystem exchange of carbon dioxide (NEE) increased with increasing woody‐plant dominance. Growing season ET totals were 407, 450, and 639 mm in the grassland, shrubland, and woodland, respectively, and in excess of precipitation by 227, 265, and 473 mm. This excess was derived from groundwater, especially during the extremely dry premonsoon period when this was the only source of moisture available to plants. Access to groundwater by the deep‐rooted woody plants apparently decouples ecosystem ET from gross ecosystem production (GEP) with respect to precipitation. Compared with grasses, the woody plants were better able to use the stable groundwater source and had an increased net CO2 gain during the dry periods. This enhanced plant activity resulted in substantial accumulation of leaf litter on the soil surface that, during rainy periods, may lead to high microbial respiration rates that offset these photosynthetic fluxes. March–December (primary growing season) totals of NEE were −63, −212, and −233 g C m−2 in the grassland, shrubland, and woodland, respectively. Thus, there was a greater disparity between ecosystem water use and the strength of the CO2 sink as woody plants increased across the encroachment gradient. Despite a higher density of woody plants and a greater plant productivity in the woodland than in the shrubland, the woodland produced a larger respiration response to rainfall that largely offset its higher photosynthetic potential. These data suggest that the capacity for woody plants to exploit water resources in riparian areas results in enhanced carbon sequestration at the expense of increased groundwater use under current climate conditions, but the potential does not scale specifically as a function of woody‐plant abundance. These results highlight the important roles of water sources and ecosystem structure on the control of water and carbon balances in dryland areas.