How Foreign Source Income Is Taxed for US Persons

As global opportunities expand, more U.S. citizens and resident aliens earn income from sources outside of the United States. Foreign source income is any income not generated from within the U.S. The U.S. government has a distinct set of rules to determine what is considered foreign income and how it is taxed, including provisions to avoid double taxation.

Determining the Source of Income

Before any tax can be calculated, income must be classified as either U.S. source or foreign source based on rules in the Internal Revenue Code. The physical location where services are performed is the definitive factor for sourcing compensation like wages and salaries. If an individual works in France for three months, the income earned during that period is foreign source, irrespective of whether the employer is an American or foreign company.

The sourcing rules for other common types of income are just as precise. Interest income is sourced to the residence of the person or entity paying the interest. Dividend income is sourced based on the country where the paying corporation is incorporated. For real estate, the rules are tied to the physical location of the property, making rental income from a London flat and the gain from its sale foreign source. Royalties from patents or copyrights are sourced to the location where the intellectual property is used.

US Taxation of Worldwide Income

The United States tax system operates on a principle of worldwide income taxation for its citizens and resident aliens. This means a U.S. person is legally required to report all income to the Internal Revenue Service (IRS), regardless of the country in which it was earned. This rule applies to all forms of income, including earned income like wages and unearned income like interest and dividends.

For example, a U.S. citizen living and working in the United Kingdom must report their British salary, any interest earned from a U.S. bank account, and dividends from a French company on their U.S. tax return. The place of residence or the currency in which the income is received does not alter this requirement.

A direct consequence of this worldwide taxation model is the potential for double taxation. An individual may be taxed by the foreign country where the income is earned and then again by the United States on that same income. To address this, the U.S. tax code provides specific mechanisms to provide relief.

The Foreign Earned Income Exclusion

One of the primary methods for mitigating U.S. tax on income earned abroad is the Foreign Earned Income Exclusion (FEIE). This provision allows qualifying individuals to exclude a significant portion of their foreign earned income from their U.S. income tax calculation. For 2024, the maximum exclusion is $126,500, and this amount is indexed for inflation. This exclusion applies only to earned income, such as salary and self-employment earnings, not to passive income like interest or dividends.

To claim the FEIE, a taxpayer must have a tax home in a foreign country and meet one of two tests: the Bona Fide Residence Test or the Physical Presence Test. The Bona Fide Residence Test is a qualitative assessment. To meet it, a U.S. citizen must prove they have established a residence in a foreign country for an uninterrupted period that includes one full calendar year. The IRS examines factors like the individual’s foreign housing and social connections to determine if their residence is genuine.

The Physical Presence Test is a quantitative measure. To qualify, a U.S. citizen or resident alien must be physically present in one or more foreign countries for at least 330 full days during any 12-consecutive-month period. These 330 days do not need to be consecutive. This test is often used by individuals on specific, long-term assignments abroad who may not intend to establish a permanent residence.

In addition to the income exclusion, qualifying individuals may also be able to claim a foreign housing exclusion or deduction. This allows for the exclusion of a portion of housing expenses that exceed a certain base amount. Both the FEIE and the housing exclusion are claimed by filing Form 2555, Foreign Earned Income, with the U.S. tax return.

The Foreign Tax Credit

A separate method for addressing double taxation is the Foreign Tax Credit (FTC). Unlike an exclusion, the FTC is a non-refundable credit that directly reduces a taxpayer’s U.S. income tax liability on a dollar-for-dollar basis. This credit is for income taxes paid or accrued to a foreign country.

The credit is allowed only for foreign taxes on income, war profits, and excess profits. Taxes that are not based on income, such as value-added tax (VAT) or property tax, are not eligible for the credit, though they may be deductible. Choosing to take a credit is more advantageous than taking a deduction, as a credit reduces the final tax bill directly, while a deduction only reduces the income subject to tax.

The amount of the Foreign Tax Credit that can be claimed is subject to a limitation. This limitation prevents a taxpayer from using foreign tax credits to reduce U.S. tax on their U.S. source income. The formula is generally calculated by dividing foreign source taxable income by total taxable income, and then multiplying that ratio by the U.S. tax liability.

If the amount of creditable foreign taxes paid exceeds this limitation, the excess credits can be carried back to the preceding tax year and then carried forward for up to ten subsequent tax years. The calculation for the Foreign Tax Credit is performed on Form 1116, Foreign Tax Credit.

Required Reporting and Disclosures

Beyond reporting income on Form 1040, U.S. persons with foreign assets have additional reporting responsibilities. These are primarily informational returns designed to promote transparency and combat offshore tax evasion.

Separate from the income tax return, U.S. persons with significant foreign financial accounts must file FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR). This form is filed electronically with the Financial Crimes Enforcement Network (FinCEN), not the IRS. An FBAR is required if the aggregate value of all foreign financial accounts exceeds $10,000 at any point during the calendar year.

Another reporting requirement is Form 8938, Statement of Specified Foreign Financial Assets, which is part of the Foreign Account Tax Compliance Act (FATCA). This form is filed with the Form 1040 tax return. The filing thresholds for Form 8938 are higher than for the FBAR and vary based on filing status and whether the taxpayer resides abroad. For a single individual living in the U.S., the threshold is met if specified assets exceed $50,000 on the last day of the year or $75,000 at any time during the year. It is possible for a taxpayer to be required to file both an FBAR and Form 8938.