Sources close to CultofMac has informed them that the smaller iPhone, which Apple is rumored to be working on will eliminate the need of internal storage, and will instead rely on cloud-based content.

.. Apple had to figure out a way to strip away some of the components to reduce both its size and cost.

Apple decided to lose some of the memory, which is by far the most expensive component of the iPhone (up to one-quarter of the device’s cost, according to iSuppli estimates).

By “some” of the memory, we mean ALL of the memory. The iPhone nano will have no memory for onboard storage of media, our source says. It will have only enough memory to buffer media streamed from the cloud.

“I’m talking strictly storage memory here,” said our source.

The report also adds that there is going to be some sort of on-board storage for the operating system, and system caching, and perhaps for photos/videos taken from the camera. Other than that, it will rely entirely on a new revamped MobileMe service for uploading and streaming content.

The device cannot surely come without any memory — what about the operating system and critical system data?

And what about pictures and movies taken by the iPhone, assuming it has a camera? No onboard memory means photos and video will have to be streamed UP to the cloud, and presumably in real-time.

This report is basically a follow-up to the recent rumors from The Wall Street Journal and Bloomberg about iPhone nano/mini which Apple is planning to launch alongside the next iPhone in summer this year.