Foreign Earned Income vs. U.S. Source Income: What Qualifies for Exclusion

If you physically work abroad, your employment income qualifies as foreign earned – even when a U.S. company pays you. According to IRS data from 2016 to 2021, 62% of Americans filing from abroad owe $0 in federal taxes after applying available exclusions and credits. The key to joining them is correctly classifying which of your incomes qualifies as foreign earned.

Income classification determines whether you can exclude up to $130,000 (2025 tax year) and/or $132,900 (2026 tax year) from U.S. taxation using the Foreign Earned Income Exclusion (FEIE). Get this right, and you’ll save thousands. Get it wrong, and you’ll either claim benefits you don’t qualify for (triggering audits) or pay unnecessary taxes.

This guide explains exactly which income counts as foreign earned versus U.S. source, with real examples for employees, freelancers, and business owners living abroad.

Not Sure Which Income Is Foreign or U.S. Source?

Share your income types and location details, and we’ll outline exactly how each category is treated for FEIE and Foreign Tax Credit purposes.

The Core Principle: Location of Work, Not Source of Payment

The IRS uses a straightforward rule for determining the source of employment income: where you physically perform the work determines the source.

Working in Barcelona for Google (U.S. company)? Foreign earned income.
Working in California for Siemens (German company)? U.S. source income.

This is the most common misconception: “My U.S. employer pays me, so it’s U.S. income.” False. Your physical location while working is what matters, not who signs your paycheck or where your employer is headquartered.

Why Income Source Classification Matters

Your income source determines which tax benefits you can claim:

Foreign earned income:

Eligible for FEIE (excludes up to $130,000 for the 2025 tax year)
Must meet Physical Presence Test or Bona Fide Residence Test
Report on Form 2555

U.S. source income:

Not eligible for FEIE
Fully taxable on your U.S. return
No special exclusions available

Foreign source passive income:

Not eligible for FEIE (passive income can’t be excluded)
Eligible for Foreign Tax Credit instead
Different form (Form 1116)

Employment Income: How W-2 Employees Classify Income

If you receive a W-2 and work as a traditional employee, your income source follows one simple rule: where you physically work.

Corporate Expats and International Assignments

Example 1: Sarah – London office of a U.S. company

Works in London for an American tech company
U.S. company processes payroll
Paid in U.S. dollars to a U.S. bank account
Income classification: Foreign earned (she works in the U.K.)
FEIE eligible: Yes, can exclude up to $130,000

Example 2: Marcus – Singapore assignment

Transferred to the Singapore office for 2 years
New York headquarters still employs him
Receives U.S. benefits and 401(k) contributions
Income classification: Foreign earned (he works in Singapore)
FEIE eligible: Yes, if he meets the physical presence or bona fide residence test

Example 3: Jennifer – Remote from Spain for a U.S. startup

Lives in Barcelona, works remotely full-time
U.S. startup has no Spanish office
All meetings via video conference
Income classification: Foreign earned (she physically works from Spain)
FEIE eligible: Yes, assuming she meets residency tests

What Doesn’t Qualify as Foreign Earned Income

U.S. work trips: If you spend 2 months working in your U.S. home office, that portion is U.S. source income. You must prorate your FEIE claim.

Stock options and RSUs: Classification depends on when and where you performed services to earn them. Options granted while working abroad but exercised after returning to the U.S. require complex allocation.

Bonuses: Source depends on where you performed services that earned the bonus, not where you receive payment.

Self-Employment Income: Where Freelancers and Contractors Stand

Self-employment income follows the same core principle: the source of the income is determined by where you perform the services.

Service-Based Businesses

If your business income primarily comes from your personal services (such as consulting, writing, design, or coaching), the income is sourced from the location where you physically perform the work.

Example 1: Tom – Freelance software developer in Portugal

Lives and works in Lisbon
Clients located in the U.S., Canada, and Europe
Invoices clients through U.S. LLC
Income classification: Foreign earned (he works from Portugal)
FEIE eligible: Yes
Additional considerations: Must pay self-employment tax (15.3%) even on excluded income

Example 2: Lisa – Online business coach in Thailand

Delivers coaching sessions via Zoom from Bangkok
All clients are U.S.-based entrepreneurs
Paid via PayPal to a U.S. account
Income classification: Foreign earned (she works from Thailand)
FEIE eligible: Yes
Tax forms needed: Schedule C, Schedule SE, Form 2555

Example 3: David – Digital nomad traveling full-time

Works as a freelance writer while traveling to 8+ countries
Never stays in one place for more than 3 months
All work performed outside the U.S.
Income classification: Foreign earned (he works abroad)
FEIE eligible: Yes, if he meets Physical Presence Test (330 days outside U.S.)

Product-Based Businesses

For businesses that sell physical products, income classification depends on where you purchase or produce the items.

If you purchase products, Income is sourced from the location where the products are purchased.

Example: Emma – Amazon FBA seller in Germany

Lives in Berlin
Purchases products from Chinese suppliers
Sells on Amazon.com to U.S. customers
Products ship from U.S. Amazon warehouses
Income classification: Mixed (foreign source for Chinese purchases)
FEIE eligible: Partially, requires allocation

If you produce products, Income is sourced where the products are made.

Example: Carlos – Craft furniture maker in Mexico

Lives in Playa del Carmen
Produces custom furniture in his workshop
Ships to U.S. customers
Income classification: Foreign earned (he produces in Mexico)
FEIE eligible: Yes

Business Ownership: Corporations and Partnerships

If you own a foreign business entity, income classification becomes more complex.

Foreign Corporations

Example: Rachel – Owns a U.K. limited company

Lives in London, owns 100% of U.K. Ltd
Provides consulting services through the company
Pays herself a salary and dividends
Income classification:
- Salary: Foreign earned (eligible for FEIE)
- Dividends: Foreign source passive income (not eligible for FEIE, use FTC instead)
Additional forms needed: Form 5471 for foreign corporation ownership

Important Warning for Business Owners

Self-employment income qualifies for FEIE exclusion, but you still owe self-employment tax (Social Security and Medicare) on the full amount. The exclusion only applies to income tax, not self-employment tax.

Example:

You earn $100,000 from freelancing in Spain
You exclude $100,000 using FEIE (pay $0 income tax)
You still owe ~$15,300 in self-employment tax

Learn more about self-employment tax for expats.

Passive Income: Why It Can’t Be Excluded

This is critical to understand: passive income cannot be excluded using FEIE, regardless of where it comes from. The FEIE only applies to earned income – money you receive for working.

Passive income uses the Foreign Tax Credit instead, which gives you a dollar-for-dollar credit for foreign taxes paid.

Rental Property Income

Source: Location of the property, not your residence.

Example 1: Property in France, you live in France

You own a rental apartment in Paris
You live in Lyon
Income classification: Foreign source
FEIE eligible: No (rental income is passive)
Tax treatment: Report on Schedule E, claim Foreign Tax Credit for French taxes paid

Example 2: Property in Florida, you live abroad

You own a condo in Miami
You live in Portugal
Income classification: U.S. source
FEIE eligible: No
Tax treatment: Report on Schedule E, fully taxable U.S. income

Learn more about U.S. tax on foreign rental income.

Investment Income

Dividends:

Source: Location where the corporation is incorporated
Foreign corporation → Foreign source dividend
U.S. corporation → U.S. source dividend
FEIE eligible: No (passive income)

Example: Stock portfolio while living abroad

You live in Spain
You own Apple stock (U.S. corporation)
You own Unilever stock (U.K. corporation)
Income classification:
- Apple dividends: U.S. source
- Unilever dividends: Foreign source
FEIE eligible: No for either
Tax treatment: Use Foreign Tax Credit for foreign taxes paid on U.K. dividends

Interest income:

Source: Residence of the payer (the bank or institution)
Foreign bank → Foreign source
U.S. bank → U.S. source
FEIE eligible: No (passive income)

Example: Savings accounts in multiple countries

French bank account: Foreign source interest
U.S. bank account: U.S. source interest
Neither eligible for FEIE
Use the Foreign Tax Credit for French taxes paid

Capital Gains

Source: Depends on the type of property sold.

Stocks and securities:

Source based on your tax home (where you primarily live and work)
If your tax home is abroad → Foreign source
FEIE eligible: No (capital gains are passive)

Real estate:

Source based on property location
Property in Germany → Foreign source gain
Property in Texas → U.S. source gain
FEIE eligible: No

Pension and Retirement Income

Source: Where you performed services to earn the pension.

Example 1: U.S. company pension while living abroad

You worked 30 years in the U.S. for IBM
You retired and moved to Costa Rica
You receive IBM pension payments
Income classification: U.S. source (you worked in the U.S. to earn it)
FEIE eligible: No (retirement income is passive)

Example 2: Foreign company pension

You worked in Germany for Siemens
You now receive a German pension
You live in the U.S.
Income classification: Foreign source
FEIE eligible: No
Tax treatment: May qualify for treaty benefits

Social Security:

Always U.S. source
Special rules apply – may be partially tax-free
FEIE eligible: No

Quick Reference: Common Income Scenarios

✓ Qualifies as foreign earned (FEIE eligible):

Salary from working in the London office of a U.S. company
Freelance income earned while living in Mexico
Consulting fees for services performed in Thailand
Online teaching income while living in Spain
Business income from products produced in Portugal

✗ Does NOT qualify as foreign earned:

Rental income from property in France (passive, use FTC)
Dividends from foreign stocks (passive, use FTC)
U.S. Social Security benefits (U.S. source, passive)
Pension from a U.S. company (U.S. source, passive)
Interest from foreign bank accounts (passive, use FTC)
Capital gains from selling investments (passive, use FTC)

How to Determine Your Income Source

Follow these steps to classify each income source:

Step 1: Identify the Income Type

Ask: Is this income from working (earned) or from investments/property (passive)?

Working: Salary, wages, freelance fees, consulting, business services
Passive: Rental income, dividends, interest, capital gains, pensions

Step 2: For Earned Income, Determine Where Work Was Performed

Ask: Where was I physically located when I performed the services?

Abroad: Foreign earned income (FEIE eligible)
In the U.S.: U.S. source income (not FEIE eligible)
Split between both: Must prorate based on days worked in each location

Step 3: For Passive Income, Apply Specific Sourcing Rules

Rental property: Source = property location
Dividends: Source = where the corporation was incorporated
Interest: Source = where the payer (bank) is located
Pensions: Source = where you worked to earn the pension
Capital gains: Source = varies by asset type

Step 4: Choose Your Tax Strategy

Foreign earned income:

Claim FEIE using Form 2555
Potentially exclude up to $130,000
Must meet Physical Presence or Bona Fide Residence test

Foreign source passive income:

Cannot use FEIE
Claim Foreign Tax Credit using Form 1116
Dollar-for-dollar credit for foreign taxes paid
Often eliminates U.S. tax liability

Common Mistakes That Trigger Problems

Mistake 1: Assuming U.S. Employer = U.S. Source Income

Wrong: “My U.S. company pays me, so I can’t claim FEIE.”
Right: Your physical work location determines source, not who pays you.

Mistake 2: Trying to Exclude Passive Income

Wrong: “I’ll use FEIE to exclude my French rental income.”
Right: FEIE only applies to earned income. Use the Foreign Tax Credit for rental income.

Mistake 3: Not Prorating Income for Partial Year

Wrong: Claiming full FEIE when you worked 3 months in the U.S. and 9 months abroad.
Right: Must prorate exclusion based on where you worked each day.

Mistake 4: Forgetting About Self-Employment Tax

Wrong: “I excluded my freelance income, so I owe nothing.”
Right: FEIE excludes income from income tax only. You still owe 15.3% self-employment tax on the full amount.

Mistake 5: Misclassifying Business Income

Wrong: Digital nomad assumes all income is U.S. source because clients are in U.S.
Right: Income source is where you physically perform the work, not where clients are located.

What This Means for Your Tax Return

Once you’ve classified your income sources, here’s what to do:

For Foreign Earned Income

Verify you meet the Physical Presence Test (330 days abroad) or the Bona Fide Residence Test
Complete Form 2555 to claim FEIE
Attach to your Form 1040
If self-employed, also complete Schedule C and Schedule SE

For Foreign Source Passive Income

Determine how much foreign tax you paid on that income
Complete Form 1116 (separate form for each income category)
Claim Foreign Tax Credit to offset U.S. tax liability
Report income on appropriate schedule (Schedule B for interest/dividends, Schedule E for rental income)

For Mixed Situations

Many expats have multiple income sources requiring different treatments:

Example: Complete tax picture

Salary from working in Germany: $95,000 → Claim FEIE, exclude entire amount
Rental property in U.S.: $18,000 → Report on Schedule E, fully taxable
Dividends from German stocks: $5,000 → Report on Schedule B, claim Foreign Tax Credit
Freelance income earned in Germany: $25,000 → Claim FEIE, but pay self-employment tax

Understanding each income source allows you to apply the correct tax treatment and minimize your U.S. tax liability.

Let Greenback Handle Your Income Classification

Correctly classifying income sources is crucial for claiming the right tax benefits. One mistake can mean thousands in unnecessary taxes or trigger an IRS audit.

Greenback is an American company founded in 2009 by U.S. expats for expats. Our CPAs and Enrolled Agents (many expats themselves living in 14 time zones) specialize in income classification for Americans abroad.

What we do for you:

Analyze all your income sources
Determine the proper classification for each
Choose optimal strategy (FEIE vs. FTC)
Complete all required forms correctly
Ensure you claim every benefit you’re entitled to

Ready to get your income classification right?

Get matched with an expat tax CPA who specializes in foreign income classification
Calculate your service cost with our transparent pricing calculator
Contact our Customer Champions with questions about your specific income situation

Get Clarity on Your FEIE Qualification

Upload your income info and we’ll break down what qualifies for exclusion, what must be taxed, and your best tax-saving approach.

This article provides general information about income source classification for U.S. taxpayers abroad. Income classification rules can be complex and depend on your specific situation, employment arrangement, and the types of income you receive. This content should not be considered specific tax advice. Always consult with a qualified tax professional regarding your unique situation. Tax laws and IRS procedures are subject to frequent changes, and the information presented reflects the current requirements as of the publication date.

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