By Carolyn A. Betts and Catherine Austin Fitts
November 8, 2010
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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:
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:
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.
On the subject of what properties are of “like kind,” in the words of the Internal Revenue Service (herein, “Service” or “IRS”):
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 ($6,000) rather than the face amount of the coins ($2,000).
(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. $20 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:
(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 $50 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:
(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:
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:
On the treatment of brokerage costs, the tax section states:
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 following are some hypothetical exchanges of precious metals holdings and some of the issues we see in connection with such exchanges:
A. Hypothetical Exchange of Unallocated Account Holding for Bullion Bars or Coins.
An investor holds gold or silver in an unallocated account or certificate program with one facility (e.g., Kitco or Perth Mint8) and elects to take delivery from the same facility in the form of bullion bars or coins, paying the facility a fabrication fee and shipping and insurance costs. A certificate fee and storage fees may have been paid by the investor prior to the exchange and while holding the metals in unallocated or certificate form.
This is a “simultaneous swap” transaction and therefore involves no timing issues and no qualified intermediary or other third-party facilitator. There is no inequality in value between the pool or certificate holdings and the value of the bullion bars or coins (except to the extent of fees) and, therefore, there is no “boot” under Rev. Rul. 72-456. Both the unallocated account or certificate and the bullion bars or coins arguably “represent an investment in gold on world markets rather than in the coins themselves” under Rev. Rul. 979-143 and, therefore, no issues of unlike exchanges of bullion or bullion-type coins for numismatic-type coins seems to exist.
One may analogize this situation to the exchange of ETF shares for bullion in the case of the iShares silver ETF and SPDR shares of the gold ETF (see above) and conclude that if the opinions of counsel for these ETFs as described above are correct, this exchange, too, would qualify for tax deferral under section 1031. One may also analogize this situation to the exchange of a fractional undivided interest in real estate for a 100% fee simple interest in real estate, which, under Private Letter Ruling No. 2007-06001 (see above) is a like-kind exchange. Notwithstanding the foregoing arguments, however, the Service has issued no revenue rulings on the treatment under section 1031 of exchanges of allocated or unallocated accounts or certificates for physical bullion or coins and, therefore, there is no assurance that the Service would approve the exchange as of “like kind.” We do not know whether the Service would make a distinction in this respect between allocated accounts and unallocated accounts, but we would argue that if the investor’s initial purchase entitled him or her to convert between allocated accounts and unallocated accounts (with or without payment of a fee, which, for purposes of determining like-kind character, should not be relevant), then the exercise of such a right does not change the “kind or character” of the investment under the like-kind exchange rules.
The basis of the investor in the bullion bars or coins would appear to include the fabrication, storage, insurance and shipping fees under Code section 1031(d) and Rev. Rul. 72-456.
B. Hypothetical Exchange of Unallocated Account Holding or Certificate for Bullion Bars or Coins to Be Purchased from a Different Precious Metals Dealer.
An investor holds the same interests as in the first scenario, but wishes to exchange his or her pool certificate or unallocated account balance for bullion bars or coins to be acquired from a third-party dealer instead of the original facility.
All of the issues relevant in the first scenario apply to this case. In addition, this is a multiparty transaction/delayed exchange involving an actual sale and purchase, and not a simultaneous swap, so the rules for identification and timing of the purchase of the replacement property (the bullion or coins) as described above would seem to apply. Therefore, the sale of the unallocated account holding or pooled certificate should occur before the purchase of the replacement property (bullion bars or coins) and the purchase of the replacement property should occur within the IRS’s prescribed time period. A qualified intermediary transaction should be effected if possible, with the investor arranging for the proceeds of sale to be directly conveyed to the bullion or coin dealer without control over the funds by the investor. The dealer may have a process for facilitation of such a transaction by a qualified intermediary and for the written identification of the replacement property to be delivered to the qualified intermediary. In our search of dealer websites, we found no reference to such an exchange system for precious metals, but we did find instances of qualified intermediary/facilitators (e.g., Entrust Group and Exeter 1031 Exchange) that appear to perform this function with respect to real estate and precious metals.9
C. Hypothetical Exchange of Unallocated Account Holding for Digital Gold or Silver.
An investor holds the same interests as in the first scenario, but wishes to exchange his or her pool certificate or unallocated account balance for digital gold or silver at GoldMoney.
Most of the issues present in the first and second scenarios are present in this case, except that here, the investor is exchanging one non-physical holding (albeit unallocated) for another non-physical holding (which is in allocated form), and the digital gold or silver may be considered to be a hybrid of currency and an investment in precious metals on world markets, since it can be used as a medium of exchange between investors who maintain “holdings” of digital gold. It is difficult to predict the Service’s position in this scenario. The argument in favor of like-kind exchange treatment of this multi-step transaction is that the unallocated account or pool certificate is convertible into the same “kind” of precious metal (i.e., gold or silver bullion bar or coin) as the GoldMoney “holding.” Note that, in any case, the allocated account or pool certificate must represent an interest in the same type of precious metal (i.e., gold or silver) as the digital currency in order to avoid the adverse result described in Rev. Rul. 82-166 (described above).
D. Hypothetical Exchange of Numismatic Coins for Pooled Interests in the Same Type of Metal Bullion, for Bullion, or for Digital Gold or Silver of the Same Metal Type.
The holder of numismatic coins wishes to exchange them for any other of the bullion-type investments described herein, either gold-for-gold or silver-for-silver.
It appears, based upon Rev. Rul. 79-143, that there is no way for this transaction to qualify for like-kind exchange treatment under section 1031.
E. Hypothetical Exchange of Shares in a Gold or Silver ETF for Bullion Bars or Coins of the Same Metal Type.
A shareholder in a gold or silver ETF wishes to exchange his or her shares for bullion bars or coins of the same type of metal (i.e., gold-for-gold or silver-for-silver).
This scenario involves issues similar to those raised in the first scenario, except that this case is complicated by the fact that the typical individual investor in ETF shares is not entitled to exchange his or her shares for gold or silver bullion held by the ETF trust. One may argue that since institutional investors and other large holders of ETF shares are entitled to exchange gold or silver for shares in amounts of at least 50,000 (for iShares) or 100,000 (for SPDR) shares, this right in itself is dispositive of the issue whether the ETF shares are of “like kind” with the underlying precious metals and the fact that the holder of a relatively small number of shares does not hold a different “kind” of interest from the interest held by the large institutional investor. We have no guidance upon which to base a prediction whether the Service would accept this argument.
F. Hypothetical Exchange of Unallocated or Allocated Account Holding/Pooled Certificate or Bullion Bars/Coin held in US storage facility for Unallocated or Allocated Account Holding/Pooled Certificate or Bullion Bars/Coin held in a non-US storage facility.
An investor holds bullion or an interest in a pool of bullion in one of forms described in the previous scenarios through a storage facility in the US and wishes to exchange such interest for a similar interest held in another country.
In addition to the issues described above, this scenario raises the issue whether the location of the holding is relevant in qualifying the exchange as a like-kind exchange under Code section 1031. Code section 1031(h)(2)(A) provides that, 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 kind. So, the question boils down to whether investment property located outside the US is “used” predominantly outside the US. The Service has provided no guidance we have found on this issue and we do not know the location of the Mexican gold pesos and Austrian gold coronas described in Rev. Rul. 76-214, so we cannot determine whether the physical location of the coins was relevant to the Service’s ruling that the two coins were of like kind.
In addition to the like kind exchange issues, note that the investor may have to make a filing of a Report of Foreign Bank and Financial Accounts (Form TD F 90-22.1) with the Department of Treasury with respect to holdings in “foreign financial institutions.”10
G. Hypothetical Exchange of Unallocated or Allocated Precious Metals Account Holding/Pooled Certificate or Bullion Bars/Coins for Shares in Precious Metals Mutual Fund or Master Limited Partnership.
An investor holds the same interests as in the first scenario, but wishes to exchange his or her pool certificate or unallocated pooled account balance for shares in a mutual fund trust (e.g., Sprott Physical Gold Trust).
The rules for section 1031 like-kind exchanges exclude stocks, bonds, notes and partnership interests from like-kind exchange treatment and, therefore, this exchange would not qualify because a mutual fund is a type of stock, and a master limited partnership is a type of partnership. The reason a [grantor] trust like that used for exchange traded funds is not disqualified is that an interest in a trust is not an interest in a separate entity, but rather represents an undivided interest in a pool of assets, similar to a tenancy-in-common interest in real estate (see, e.g., Private Letter Ruling No. 2007-06001 described above).
H. Hypothetical Exchange of Gold Numismatic-Type Coins for Silver Numismatic-Type Coins.
An investor who holds gold collectible coins (i.e., “numismatic-type” coins wishes to exchange them for silver collectible coins.
The Service has provided no specific guidance on this point, but it has been suggested that such an exchange may qualify as a like-kind exchange:
Since, in Rev. Rul. 82-166 the Service ruled that the exchange of gold bullion for silver bullion is not a like-kind exchange because silver and gold are intrinsically different metals and primarily are used in different ways, this is an intriguing suggestion. The argument to be made is that gold numismatic coins and silver numismatic coins, unlike the metals themselves, are used in the same way and are valued in the same manner. Whether the Service would agree with this position is uncertain, of course.
Investing in precious metals often involves tax considerations that are new or unfamiliar to many individual and institutional investors. Because gains on precious metals as tangibles involve higher tax rates than is the case for financial assets and because we are in a long term bull market for precious metals resulting in potential capital gains, it is especially important that investors familiarize themselves with the tax issues of the precious metal options they consider and seek counsel of trustworthy tax professionals if significant tax consequences are at stake. This includes ensuring that their ability to move their holdings between depositories and/or jurisdictions does not give rise to unexpected or avoidable taxable events.
We hope that gathering the research in this article will help your tax professionals advise you on the unique considerations that may be relevant to changes in your precious metals holdings. We also hope that the complexity of this subject does not deter you from holding or investing in precious metals, which should be an integral part of household assets, business reserves and modern portfolios.
Carolyn Betts is an attorney in private practice in Ohio who serves as general counsel to Solari, Inc. and Solari Investment Advisory Services, LLC. Catherine Austin Fitts is the president of Solari, Inc. and the managing member of Solari Investment Advisory Services, LLC.
Wikipedia on Section 1031 Like-kind Exchanges
James F. Ivers III, “The Gold Standard: Income Tax Treatment of Investments in Gold and other Precious Metals” (April 20, 2010), The Wealth Channel, [Note that this article also includes information on what types of gold and silver investments may be held in qualified investment vehicles like IRAs).
Don Dion, “Currency, Precious Metal and Futures ETFs: Don’t Get Caught in the Tax Trap” Seeking Alpha (May 9, 2008)
Robert W. Wood, “Ten Things to Know about Like Kind Exchanges” Forbes.com (January 26, 2010)
1This includes precious metals trust-form ETFs that hold precious metals (as opposed to ETFs that hold mining stocks or precious metals futures), coins and bars, digital gold and silver, jewelry and gold, silver and platinum “certificates” representing allocated and unallocated holdings, but does not include precious metals mutual fund shares, ETFs that hold mining stocks or precious metals futures and common shares of mining companies. An exception to this rule is taxation of gold and silver held through passive foreign investment companies (like Central Fund of Canada) when filing a “QEF” election, in which case the sale qualifies for taxation at ordinary income tax rates. See, this IRS publication on passive foreign investment companies and the prospectus for Central Fund of Canada, page 15, “QEF Election.”
1See, Office of Chief Counsel Memorandum, CC:ITA:B01:LAAyres (May 2, 2008), which provides that shares of precious metals ETFs in trust form that invest in precious metals are taxed as collectibles (available at http://www.irs.gov/pub/lanoa/pmta01809_7431.pdf). See also, Rev. Rul. 90-7,1990-1 C.B. 153 (a certificate holder in an investment trust that has a single class of ownership interests and a fixed portfolio of stocks does not recognize gain or loss when the certificates are exchanged for a proportionate share of each of the trust’s assets); Rev. Rul. 85-13, 1985-1 C.B. 184 (a grantor acquired the corpus of a trust in exchange for the grantor’s unsecured promissory note. The grantor is considered to have borrowed the corpus of the trust and, as a result, is treated as the owner of the trust under § 675(3). Because the grantor is treated as the owner of the trust, the grantor is deemed the owner of the trust assets for federal income tax purposes.); and Rev. Rul. 84-10, 1984-1 C.B 155 (a beneficial owner of a widely held mortgage trust is treated for federal income tax purposes as having a proportionate share of equitable ownership in each of the mortgages of the trust).
2The term “non-taxable” exchange is something of a misnomer, since the tax is actually only deferred until a later date when a taxable disposition takes place. An exception is that an intervening death of the exchangor does result in a tax-free step up in basis to the exchangor’s heir.
6Page 32 of the prospectus. The tax treatment described in the prospectus was provided by the law firm of For a more detailed description of the iShares fund, see, Catherine Austin Fitts and Carolyn Betts, “GLD and SLV: Disclosure in the Precious Metals Puzzle Palace,” The Solari Report, (July 8, 2010), Section III.
7Another interesting and generally relevant aspect of the tax discussion concerns determining basis in shares purchased on different dates when fewer than all of the taxpayer’s shares are disposed of. Carter Ledyard’s tax analysis states:
8Note that, according to their respective websites, in the case of Kitco non-allocated pool accounts, “there is always physical bullion present in [the Kitco] vaults to account for 100% of the outstanding client balances in all Kitco Pool Accounts,” whereas in the case of Perth Mint, the Mint may (and probably does) “borrow” the investors’ precious metals for use in its industrial operations, so that no actual metals are held in segregated safekeeping for certificate holders.
9Reference to these qualified intermediaries is made solely to provide information about the types of services that may be available and does not represent an endorsement of these service providers, upon which we have done no due diligence.
10See, Donald W. Dee, “1031 Exchanges and How They Apply to Numismatic Coins and Bullion,” under the section entitled “Section 1031 Exchanges and Coins,” available at the Steptoff Investment Group LLC.