Global warming may intensify the hydrological cycle and lead to increased drought severity and duration, which could alter plant community structure and subsequent ecosystem water and carbon dioxide cycling. We report on the net ecosystem exchange of carbon dioxide (NEE) of a semidesert grassland through a severe drought which drove succession from native bunchgrasses to forbs and to eventual dominance by an exotic bunchgrass. We monitored NEE and energy fluxes using eddy covariance coupled with meteorological and soil moisture variables for 6 years at a grassland site in southeastern Arizona, USA. Seasonal NEE typically showed a springtime carbon uptake after winter-spring periods of average rainfall followed by much stronger sink activity during the summer rainy season. The two severe drought years (2004 and 2005) resulted in a net release of carbon dioxide (25 g C m−2) and widespread mortality of native perennial bunchgrasses. Above average summer rains in 2006 alleviated drought conditions, resulting in a large flush of broad-leaved forbs and negative total NEE (−55 g C m−2 year−1). Starting in 2007 and continuing through 2009, the ecosystem became increasingly dominated by the exotic grass, Eragrostis lehmanniana, and was a net carbon sink (−47 to −98 g C m−2 year−1) but with distinct annual patterns in NEE. Rainfall mediated by soils was the key driver to water and carbon fluxes. Seasonal respiration and photosynthesis were strongly dependent on precipitation, but photosynthesis was more sensitive to rainfall variation. Respiration normalized by evapotranspiration showed no interannual variation, while normalized gross ecosystem production (i.e., water use efficiency) was low during drought years and then increased as the rains returned and the E. lehmanniana invasion progressed. Thus, when dry summer conditions returned in 2009, the potential for ecosystem carbon accumulation was increased and the ecosystem remained a net sink unlike similar dry years when native grasses dominated ecosystem structure.