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The valves on each end allow water into and out of the heater. The one in the middle will let water bypass the heater if the water is shut off of the in and out sides of the heater. This is if you want to drain your water heater in the winter and put antifreeze in the rest of the system. Generally the valve handles are set up to indicate the direction the water flows.
Water should be flowing in and out of water heater and the handle in the center should not allow water to pass.
There should be no difference in the setting for both city and fresh water tank usage.
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