In our May 2010, Solari Special Report "GLD & SLV: Disclosure in the Precious Metals Puzzle Palace: An Analysis of the Precious Metals ETFs" we raised questions about the safety of investments in precious metals in the form of shares of exchange-traded funds, which represent undivided interests in pools of precious metals held by custodians with direct accountability for holdings only to the fund sponsors.
In our August 2010 Solari Special Report, "Options for Storing Precious Metals" we explored some of the different forms of more direct precious metals holdings and third-party storage facilities that facilitate such holdings. These included:
bank and nonblank safe deposit boxes and vaults for storage of bullion, coins and other precious metals where the purchases are either made independently by investors or facilitated by the storage facility;
allocated and unallocated accounts with precious metals refineries (e.g., Perth Mint) and other combination bullion purchase and storage facilities;
segregated and non-segregated precious metals accounts with custodians that hold coins and bars for institutional investors, typically holding for IRA and other qualified accounts; and
"digital" holdings in the form of undivided interests in allocated pools of precious metals or specifically-identified, numbered bars (i.e., GoldMoney).
We saw that, generally speaking, less expensive storage fees apply to unallocated and/or unsegregated account holdings, and that in some cases the physical precious metals held in unallocated accounts may actually be "borrowed" from the investor for use by others. Some holdings are identified by certified coin number or bar number, while others are fungible with the holdings of other customers, either on a segregated or unsegregated basis. Some storage facilities permit an investor to convert a precious metals holding from one form to another, e.g., from an unallocated account or undivided interest in a pool to specifically-identified, numbered bars or coins to which the investor can take physical delivery (upon the payment of a fabrication fee). For institutional investors, shares of gold and silver ETFs may be exchanged for bullion, and bullion may be exchanged for ETF shares.
Another form of precious metals holding is a commodity future, consisting of an option to purchases metals at a designated future date at a stated price. In theory, the holder of such an option can take delivery of the metals, although options contracts generally are settled without any of the underlying commodity changing hands.
So, what happens from a tax standpoint when an investor converts his or her holdings of precious metals from one form to another? This question arises when holders of unallocated positions decide to shift their holdings into an allocated form or into jurisdictions which they perceive to be more respectful of their property rights.
The significance of this question is that if such an exchange is deemed to be the sale of one holding and a separate purchase of a new one, any gain is taxable for the year of the exchange at long term capital gains tax rates (assuming the holding period is at least twelve months). In the case of virtually all forms of precious metals holdings,1 long term capital gains are taxed at the higher 28% rate for collectibles, rather than at the usual 15% rate currently in effect through 2010 for other capital asset classes.
In this Report, we identify and summarize certain IRS revenue rulings and other guidance that may apply to precious metals exchanges and the determination whether and under what circumstances the conversion of precious metals holdings from one form to another may result in a non-taxable2 exchange under section 1031 of the Internal Revenue Code ("Code"). We also provide links to articles that provide more generalized explanations of basis, identification requirements and timing issues, the use of "qualified intermediaries," the concept of "boot" (where part of the exchange is in the form of cash, because the items being exchanged are not of exactly equal value), and taxation of precious metals in general.
This report deals only with U.S. federal law and is not intended as a substitute for an analysis by an expert legal or tax advisor relative to a particular situation, but rather is intended to assist investors and practitioners in identifying some of the relevant issues and questions to be considered before entering into an exchange.
We have not done due diligence on the companies and arrangements described herein as examples and highly recommend that an investor do his or her own due diligence before choosing a company or advisor with which to do business. There may be additional, important issues we have not identified (including tax ramifications under applicable US state law and laws of other countries), investment situations we have not considered and forms of precious metals holdings and exchanges we have not thought of. Readers are strongly urged to seek tax counsel before making any investment or purchase decision that may have significant tax consequences.
II. INTERNAL REVENUE CODE SECTION 1032: REQUIREMENTS GENERALLY FOR SECTION 1031 LIKE-KIND EXCHANGE TREATMENT
Section 1031(a)(1) of the Code provides that, in general:
"No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment."3
Generally, the requirements for a Code section 1031 exchange are:
- Exchange of property held for productive use in a trade or business or for investment – this applies to both the relinquished property and the replacement property.
- The taxpayer may be an individual, C or S corporation, limited or general partnership, limited liability company, partnership or trust.
- The property relinquished must be of "like kind" to the property received in the exchange.
- For delayed exchanges, the replacement property must be identified (in writing) within 45 days and the exchange completed not more than 180 days after transfer of the exchanged property, or the due date (including extensions) of the tax return for the year of the sale of the relinquished property, whichever is earlier. The written identification must be delivered to the seller of the replacement property or a "qualified intermediary" or other third party who is not an agent or advisor of the taxpayer. The relinquished property must be disposed of before the replacement property is acquired. To accomplish this, a third-party facilitator ("qualified intermediary") may be used to hold title to the identified replacement property pending disposition of the property to be replaced.4 If the taxpayer takes control of the proceeds of the sale of the relinquished property before the exchange is complete, the tax-deferred nature of the exchange may be lost.
- The basis of the replacement property is the basis of the property relinquished, with certain adjustments [for costs of sale, etc.]
- If property other than like-kind property or cash is received or paid in addition to the like-kind property exchange, the "boot" is taxed.
- Special rules apply to exchanges between related persons.
(a) stock in trade or other property held primarily for sale,
(b) stocks, bonds, or notes,
(c) other securities or evidences of indebtedness or interest,
(d) interests in a partnership,
(e) certificates of trust or beneficial interests, or
(f) choses in action.
(g) Real property outside the United States and real property located in the United States are not of like kind. In general, personal property used predominantly within the United States and personal property used predominantly outside the United States is not property of a like (section 1031(h)).
On the subject of what properties are of "like kind," in the words of the Internal Revenue Service (herein, "Service: or "IRS"):
"Section 1.1031(a)-1(b) of the Income Tax Regulations provides that as used in section 1031(a) of the Code, the words 'like kind' have reference to the nature or character of the property and not to its grade or quality. One kind or class of property may not, under that section, be exchanged for property of a different kind or class."
Generally, the rules for like-kind exchanges of real property are more liberal than are those for personal property. Virtually any real property may be exchanged for another real property and still qualify for section 1031 treatment, although an exchange of real property located in one country for real property in another does not qualify.
A. IRS Revenue Rulings on Taxation of Precious Metals and whether Exchanged and Replaced Metals Are of "Like Kind" [in order of date]
(1) Rev. Rul. 74-218, 1974-1 C.B. 202 – Currency in its usual and ordinary acceptation is defined as gold, silver, other metals or paper used as a circulating medium of exchange. Silver coins received for real property are to be treated as property and not as money; the amount realized by the taxpayer from the exchange was the fair market value of the silver coins (,000) rather than the face amount of the coins (,000).
(2) Rev. Rul. 76-214, 1976-1 C.B. 218 – The exchange of Mexican 50-peso gold coins for Austrian 100-corona gold coins, both of which are official government restrikes [and "bullion-type" coins], qualifies for nonrecognition of gain under section 1031(a) of the Code.
(3) Rev. Rul. 76-249, 1976-2 C.B. 21 – A taxpayer who receives U.S. silver coins having a value in excess of their face value in exchange for appreciated real property realizes a taxable gain based on the excess of the fair market value of the coins over the adjusted basis of the real property.
(4) Rev. Rul. 79-143, 1979-1 C.B. 264 – The exchange of U.S. gold coins (numismatic-type coins) for South African Krugerrand gold coins (bullion-type coins) does not qualify for nonrecognition of gain as a like kind exchange under section 1031 of the Code.
In this ruling, the Service provided the following reasoning:
"[A]lthough the coins appear to be similar because they both contain gold, they actually represent totally different types of underlying investment, and therefore are not of the same nature or character. The bullion-type coins, unlike the numismatic-type coins, represent an investment in gold on world markets rather than in the coins themselves. Therefore, the bullion-type coins and the numismatic-type coins are not property of like kind."
(5) Rev. Rul. 82-96 – The exchange of gold bullion for Canadian Maple Leaf gold coins (which are legal tender in Canada to the extent of face value of each) qualifies for nonrecognition of gain or loss as a like kind exchange under section 1031(a) of the Code.
In this ruling, the Service provided the following reasoning:
"[B]ecause the value of the gold content in each Canadian Maple Leaf gold coin greatly exceeds its face value, it is not a circulating medium of exchange. Therefore, the Canadian Maple Leaf gold coin is property rather than money for purposes of section 1031(a) of the Code. Because the Canadian Maple Leaf gold coins are bought and sold for their gold content, they are bullion-type coins. Therefore, the nature and character of the gold bullion and the Canadian Maple Leaf gold coins are the same, and they qualify as 'like kind' property as that term is used in section 1.1031(a)-1(b) of the regulations."
(6) Rev. Rul. 82-166 – The exchange of gold bullion held for investment for silver bullion held for investment does not qualify for nonrecognition of gain as an exchange of like kind property.
In this ruling, the Service provided the following reasoning:
"[T]he values of the silver bullion and the gold bullion are determined solely on the basis of their metal content. Although the metals have some similar qualities and uses, silver and gold are intrinsically different metals and primarily are used in different ways. Silver is essentially an industrial commodity. Gold is primarily utilized as an investment in itself. An investment in one of the metals is fundamentally different from an investment in the other metal."
B. Potentially Relevant IRS Revenue Guidance on Real Property Exchanges
Private Letter Ruling No. 2007-06001 (PLR 200706001) – exchange of undivided 25% interest in real property for 100% fee simple interest in another parcel of real property is like kind exchange.
C. Other Internal Revenue Service Rulings of Interest
Rev. Rul. 72-456 – Money paid out in connection with an exchange under section 1031 of the Code is offset against money received in computing gain realized and gain recognized and is also added in determining the basis of the acquired property [based upon section 1.1031(d)-2 of the Income Tax Regulations]. If, upon an exchange of properties of the type described in section 1031 of the Code, the taxpayer received other property (not permitted to be received without the recognition of gain) and gain from the transaction was recognized as required under section 1031(b) of the Code, the basis of the property transferred by the taxpayer, decreased by the amount of any money received and increased by the amount of gain recognized, must be allocated to and is the basis of the properties (other than money) received on the exchange [based upon section 1.031(d)-1(c) of the Income Tax Regulations].
Private Letter Ruling No. 2008-07005 (February 15, 2008 release date) – Taxpayer's receipt of 100 percent of the interests of the partners in a partnership that holds real property, by a disregarded entity created by Taxpayer to receive the real property, will be treated as the receipt of property that is like kind to the real property disposed of by Taxpayer, provided all other requirements of section 1031 are met.
D. Law Firm Tax Opinions
The tax section of the iShares silver exchange traded fund,6 provided by the law firm of Clifford Chance US LLP, New York, states that an exchange of silver for shares (called "iShares") in the fund (which is a trust the interests of which represent undivided interests in the underlying assets, consisting of silver bullion) is non-taxable, and that a redemption of iShares in exchange for the underlying silver likewise generally will not be taxable. Presumably, Clifford Chance’s conclusion is based on its conclusion that such exchanges satisfy the requirements for a like-kind exchange under Code section 1031.
The tax section of the SPDR Gold Trust gold exchange traded fund prospectus (starting on page 31), provided by the law firm of Carter Ledyard & Milburn LLP, states:
"In the case of a Shareholder that acquires its Shares as part of a creation, the delivery of gold to the Trust in exchange for the underlying gold represented by the Shares will not be a taxable event to the Shareholder, and the Shareholder’s tax basis and holding period for the Shareholder’s pro rata share of the gold held in the Trust will be the same as its tax basis and holding period for the gold delivered in exchange therefore. For purposes of thisdiscussion, it is assumed that all of a Shareholder’s Shares are acquired on the same date, at the same price per Share and, except where otherwise noted, that the sole asset of the Trust is gold. . . A redemption of some or all of a Shareholder’s Shares in exchange for the underlying gold represented by the Shares redeemed generally will not be a taxable event to the Shareholder."
On the treatment of brokerage costs, the tax section states:
"Any brokerage or other transaction fee incurred by a Shareholder in purchasing Shares will be treated as part of the Shareholder’s tax basis in the underlying assets of the Trust. Similarly, any brokerage fee incurred by a Shareholder in selling Shares will reduce the amount realized by the Shareholder with respect to the sale."
Again, we assume that the basis for this opinion is Code section 1031 and that Carter Ledyard & Milburn concludes that the acquisition as part of a "creation" (which is an exchange by an "authorized participant" of physical gold for at least 100,000 Shares of the SPDR Gold Trust representing undivided interests in the underlying gold).7
The tax section of the prospectus for Sprott Physical Gold Trust (a Canadian mutual fund trust) states on page 96:
"As described under "Redemption of Units," a U.S. Holder may have units redeemed for cash or physical gold bullion. Under Section 302 of the Code, a U.S. Holder generally will be treated as having sold his, her or its units (rather than having received a distribution on the units) upon the redemption of units if the redemption completely terminates or significantly reduces the U.S. Holder's interest in the Trust. In such case, the redemption will be treated as described in the relevant section below depending on whether the U.S. Holder makes a QEF election, a mark-to-market election or makes no election and therefore is subject to the Default PFIC Regime…
"Gain realized on the sale, exchange, redemption or other disposition of the units would be treated as ordinary income, and any loss realized on the sale, exchange, redemption or other disposition of the units would be treated as ordinary loss to the extent that such loss does not exceed the net mark-to-market gains previously included by the U.S. Holder. Any loss in excess of such previous inclusions would be treated as a capital loss by the U.S. Holder. A U.S. Holder's ability to deduct capital losses is subject to certain limitations. Any such gain or loss generally should be treated as U.S.-source income or loss for U.S. foreign tax credit limitation purposes."
California Life Insurance Co. v. Commissioner, 680 F.2d 85, (9th Cir.1982) – Gold coins and Swiss francs were not of like kind. The coins are exchanged in the marketplace only by numismatists, and are valued primarily for their rarity, as collector items. The Swiss francs, on the other hand, are currently circulating currency, and to their investors they represent investments in the Swiss national economy.
Starker v. United States, 602 F.2d 1341, 79-2 U.S. Tax Case. (CCH) paragr. 9541, 44 A.F.T.R.2d 79-5525 (9th Cir. 1979) – The sale of the relinquished property and the acquisition of the replacement property do not have to be simultaneous. Further:
"The bundle of rights associated with ownership are obviously not excluded from section 1031; a contractual right to assume the rights of ownership should not, we believe, be treated as any different than the ownership rights themselves. Even if the contract right includes the possibility of the taxpayer receiving something other than ownership of like-kind property, we hold that it is still of a like kind with ownership for tax purposes when the taxpayer prefers property to cash before and throughout the executory period, and only like-kind property is ultimately received."
To continue reading the Solari Report, Tax Issues Regarding Precious Metals Holdings click the editorial link.