Transitions from grass- to shrub-dominated states in drylands by woody plant encroachment represent significant forms of land cover change with the potential to alter the spatial distribution and cycling of soil resources. Yet an understanding of how this phenomenon impacts the soil nitrogen pool, which is essential to primary production in arid and semiarid systems, is poorly resolved. In this study, we quantified how the distribution and speciation of soil nitrogen, as well as rates of free-living biological nitrogen fixation, changed along a gradient of increasing mesquite ( Prosopis velutina Woot.) cover in a semiarid grassland of the Southwestern US. Our results show that site-level concentrations of total nitrogen remain unchanged with increasing shrub cover as losses from intershrub areas (sum of grass and bare-soil cover) are proportional to increases in soils under shrub canopies. However, despite the similar carbon-to-nitrogen ratio and microbial biomass of soil from intershrub and shrub areas at each site, site-level concentrations of inorganic nitrogen increase with shrub cover due to the accumulation of ammonium and nitrate in soils beneath shrub canopies. Using the acetylene reduction assay technique, we found increasing ratios of inorganic nitrogen-to-bioavailable phosphorus inhibit rates of biological nitrogen fixation by free-living soil bacteria. Consequently, we conclude that shrub encroachment has the potential to significantly alter the dynamics of soil nitrogen cycling in dryland systems.