Understanding Foreign Income Reporting and Sourcing Rules for U.S. Taxpayers
The U.S. tax system is based on citizenship and residency, meaning that U.S. citizens, green card holders, and tax residents are generally taxed on their worldwide income — not just income earned inside the U.S.
This includes wages, dividends, interest, rental income, capital gains, and business profits earned abroad. Reporting these amounts correctly on your U.S. tax return is essential, even if the income is already taxed in the foreign country.
General Foreign Income Reporting
The general rule is simple:
Report all foreign income on your U.S. tax return, no matter where it was earned or whether you bring it into the U.S.
Examples of foreign income that must be reported:
Salary or wages earned while working abroad.
Interest from foreign bank accounts.
Dividends from foreign companies.
Rental income from foreign real estate.
Capital gains from selling foreign assets.
Foreign business or self-employment income.
Even if the income is small or was already taxed overseas, it must still be reported.
Foreign Sourcing Rules
Understanding how income is sourced is important because it determines:
Whether foreign taxes can be credited or deducted.
Whether the U.S. has primary or secondary taxing rights (especially under tax treaties).
Here’s a simplified overview of sourcing rules:
Type of Income & Sourcing Rules
Wages/Personal Services - where the services are physically performed.
Interest Income - residence of the payer.
Dividend Income - country of incorporation of the paying company.
Rental Income - location of the property.
Sale of Non-real Estate Property - generally where the seller is resident.
Sale of Real Property - location of the real property.
Example:
If you work for a U.S. company but perform the work while living in Germany, the wages are generally foreign-source income — even though the employer is American.
Foreign Tax Credits and Deductions
Since the U.S. taxes foreign income, there’s a risk of double taxation — once by the foreign country and again by the U.S. To reduce this burden, taxpayers can usually:
Claim the foreign tax credit (using IRS Form 1116) to offset U.S. tax liability by the amount of foreign taxes paid.
Elect a deduction for foreign taxes (though the credit is usually more beneficial).
Note: The foreign tax credit applies only to foreign-source income, so understanding how income is sourced is critical for correct application.
This topic is discussed in more depth on the Double Taxation Relief page of this website.
Common Exclusions and Special Rules
Certain taxpayers may also qualify for the Foreign Earned Income Exclusion (FEIE) (Form 2555), which allows eligible individuals to exclude up to $130,000 (for 2025; inflation-adjusted) of foreign earned income if they meet specific residence or physical presence tests.
However, this exclusion applies only to earned income (such as wages), not passive income like dividends or rental profits.
This topic is discussed in more depth on the Double Taxation Relief page of this website.
Why Proper Reporting and Sourcing Matter
Failure to report foreign income can result in IRS penalties, audits, and loss of eligibility for certain credits or exclusions.
Misapplying sourcing rules can lead to overpaying tax or improperly claiming foreign tax credits.
Income sourcing also affects U.S. withholding rules, treaty applications, and state tax obligations.
Key Takeaways
U.S. taxpayers must report all worldwide income, including foreign income.
Income sourcing rules determine how income is classified and how foreign tax credits apply.
Foreign taxes paid can often be credited or deducted to avoid double taxation.
Special exclusions (like the FEIE) may reduce taxable income if you qualify.
Because cross-border tax rules are complex, it’s a good idea to review IRS publications (such as Pub 54) and consider working with a tax professional familiar with international reporting.
For detailed sourcing examples, tax credit calculations, and foreign earned income rules, consult IRS resources on international tax compliance or click Contact to schedule a call with a cross-border tax specialist.