American Realty Trust v. United States

American Realty Trust (ART) (plaintiff) was a real estate investment trust formed in 1961 that sought favorable tax treatment under the Internal Revenue Code. To that end, ART was required to pay out at least 90 percent of its taxable income as shareholder dividends. On January 29, 1965, ART entered into a sale-and-leaseback transaction with Harry Helmsley, a real estate entrepreneur, pursuant to which Helmsley sold a resort property to ART for $7 million. Of the total sale price, $2.5 million was paid in cash, and the remaining $4.5 million was subject to a mortgage. On February 8, 1965, the parties entered into the lease portion of the transaction, pursuant to which Helmsley paid a net yearly rental of $645,000. Helmsley was also responsible for all operating expenses, taxes, levies, insurance, repairs, and capital improvements. The lease also contained an option agreement that granted Helmsley the option to repurchase the property at annually decreasing price intervals between August 1969 and August 1972. On September 17, 1971, Helmsley assigned the option to one of his wholly owned corporations and exercised the purchase option. Helmsley later testified that he exercised the option because it enabled him to purchase the property with little cash outlay of his own. Meanwhile, in the years prior to Helmsley’s repurchase of the property, ART deducted all mortgage interest payments and depreciation costs from its taxable income. The Internal Revenue Service (IRS) (defendant) later audited ART’s 1968 federal income tax return and determined that the transaction between ART and Helmsley did not result in the true transfer of ownership and was instead effectively a loan from ART to Helmsley. According to the IRS, the depreciation and interest deductions were unlawful. The commissioner of the IRS denied the deductions and recharacterized Helmsley’s rental payments as interest on the ART loan. This recharacterization substantially increased ART’s taxable income and caused ART to fall out of compliance with the IRS’s rules for dividend distributions for real estate investment trusts. This created increased tax liability. ART paid the tax and sought to recover a refund. At an administrative adjudication, the IRS upheld the tax. ART then filed suit in the federal district court, where a jury found in favor of ART. The jury found that the transaction was not solely motivated by tax considerations and that it was made in good faith with legitimate commercial considerations. The government appealed.