What Is U.S. Source Income and How Is It Taxed?

U.S. source income is any income the IRS treats as arising within the United States under a set of category-by-category geographic rules, and when it’s paid to a nonresident alien or foreign entity it’s generally taxed at a flat 30% on the gross amount unless a tax treaty, a statutory exemption, or an election lowers that rate. The same person can have some U.S. source income and some foreign source income in the same year, because the test is different for wages, interest, dividends, rents, royalties, and gains. Getting the source right is what determines whether the United States can tax the payment at all, and at what rate.

Compensation for Work Performed in the United States

For personal services, the source is where you physically did the work. Pay for services performed inside the United States is U.S. source income, regardless of where the employer is based, where the contract was signed, or where the money is deposited.¹

A narrow exception applies to short business visits. A nonresident alien whose stay totals 90 days or fewer in the tax year, whose compensation for those U.S. services is $3,000 or less, and whose employer is a foreign person not engaged in a U.S. trade or business, has foreign source pay. All three conditions must be met; missing one pulls the entire amount back into U.S. source.¹

When work is split between the U.S. and abroad, compensation is allocated on a time basis: the ratio of days worked in the U.S. to total days worked determines the U.S. source portion.²

Interest

Interest is sourced to the residence of the payer, not the location of the account. Interest paid by a U.S. resident individual or a domestic corporation is U.S. source income; interest paid by a foreign person is foreign source.¹³

Not all U.S. source interest ends up taxed. Portfolio interest received by a nonresident alien is exempt from the 30% withholding tax if the debt is in registered form and the beneficial owner certifies on Form W-8BEN that they are not a U.S. person. The exemption does not apply if the recipient owns 10% or more of the voting stock of a corporate borrower, or 10% or more of the capital or profits interest of a partnership borrower.⁴ This is the exemption that lets foreign investors hold U.S. Treasury and corporate bonds without withholding.

Dividends

Dividends from a domestic corporation are U.S. source income. The test is the payer’s place of incorporation, not where the company earns its profits or where the shareholder lives.¹ A nonresident alien receiving these dividends is subject to the 30% withholding tax unless a treaty lowers the rate.⁴ The withholding agent, typically the broker or transfer agent, deducts the tax before the shareholder receives the payment.

Rents and Royalties

Rent is sourced to where the property sits. Rent from real estate or equipment located inside the United States is U.S. source income. Royalties for the use of intangibles such as patents, copyrights, trademarks, trade secrets, and franchises are sourced to where the intangible is used, so royalties tied to sales in the American market are U.S. source.¹

The Net Basis Election for Real Property Rent

Rental income from U.S. real property is normally taxed at 30% on gross receipts, with no deduction for mortgage interest, depreciation, repairs, or management fees. A nonresident alien or foreign corporation may elect to treat all U.S. real property income as effectively connected with a U.S. trade or business, which switches taxation to graduated rates on net income and allows those expenses to come off. The election is made by attaching a statement to the return, covers all U.S. real property income together, and stays in effect until formally revoked.⁵ For anyone with real operating costs, this election almost always produces a lower bill.

Gains on U.S. Real Estate

Gain from selling a U.S. real property interest is U.S. source income and is treated by statute as effectively connected with a U.S. trade or business, so it is taxed at the same graduated rates that apply to U.S. taxpayers rather than the flat 30%.¹⁶

Under FIRPTA, when a foreign person sells U.S. real property the buyer must withhold 15% of the total sale price and send it to the IRS. The rate drops to 10% if the property will be the buyer’s personal residence and the price is $1 million or less. The withholding is a prepayment, not an additional tax, and a seller whose actual liability is lower files a return to recover the excess.⁷

Gains on Personal Property and Inventory

For most personal property that is not real estate or inventory, the default source rule follows the seller’s tax home. Gain realized by a nonresident alien whose tax home is outside the U.S. is foreign source; gain realized by a U.S. resident on the same asset is U.S. source. A tax home is generally the principal place of business, or where the person regularly lives if there is none.⁸

Inventory has its own rule. When goods are purchased outside the U.S. and sold inside the U.S., profit is U.S. source, and the place of sale is fixed by where title to the goods passes. Shipping terms and the sales contract determine that point.¹

The 183-Day Rule for Capital Gains

A nonresident alien who is physically present in the United States for 183 days or more during the tax year is subject to a flat 30% tax on U.S. source capital gains, even on gains realized during periods spent abroad in that same year. This 183-day count is separate from the substantial presence test that determines residency.⁹ Students and scholars on F, J, M, or Q visas should watch this threshold; a treaty may cut or eliminate the tax, but without one the presence itself creates the liability.

Pensions and Annuities

Pension and annuity payments are U.S. source to the extent they trace back to services performed in the United States. Someone who worked for a U.S. employer for years and then retired abroad continues to have U.S. source pension income for the portion attributable to those U.S. work years. Investment earnings inside a domestic pension trust are U.S. source based on the trust’s location.¹⁰

The tax then splits. The portion tied to employer contributions for post-1986 U.S. services is treated as effectively connected income and taxed at graduated rates. Other portions, such as investment earnings, are taxed at the flat 30% as passive income, unless a treaty reduces or eliminates the tax. Some treaties fully exempt Social Security pensions.¹¹ To have the payer withhold at graduated rates rather than 30%, the recipient submits Form W-8BEN or Form 8233 before the distribution is paid.¹⁰

Scholarships, Fellowships, and Prizes

Scholarship and fellowship income is sourced to the residence of the payer, not the location of the school. A grant from a U.S. organization is U.S. source; a grant from a foreign government is foreign source even when it funds study at an American university.

Not every dollar of a U.S. source scholarship is taxable. For a degree candidate, amounts used for tuition, required fees, books, supplies, and equipment are excluded from gross income as a qualified scholarship. Amounts covering room and board, travel, or general living expenses are taxable, and any part that is payment for required teaching or research services is taxable even if the school calls it a fellowship.¹²

Students on F, J, M, or Q visas face a reduced 14% withholding rate on the taxable portion of a scholarship, rather than 30%. Some treaties eliminate the tax entirely under a student article.¹¹ Prizes and awards from events held in the United States are U.S. source and taxed at 30% as part of the broader category of fixed or determinable annual or periodical income.⁴

Two Tax Tracks: FDAP and Effectively Connected Income

Once income is U.S. source, how it is taxed depends on which of two categories it falls into. The distinction produces very different bills.

FDAP: Flat 30% on Gross

Fixed, determinable, annual, or periodical income covers interest, dividends, rents, royalties, annuities, and similar recurring payments. FDAP income paid to a nonresident alien is taxed at a flat 30% on the gross amount, with no deductions. The withholding agent takes the tax out before the recipient sees the money.⁴

ECI: Graduated Rates on Net

Income effectively connected with a U.S. trade or business is taxed at the same graduated rates that apply to U.S. citizens and residents, currently topping out at 37% for individuals and 21% for corporations, but on net income after business deductions. That usually produces a lower effective rate than 30% on gross.¹³

To be engaged in a U.S. trade or business, activities have to be considerable, continuous, and regular. Performing personal services in the U.S. generally counts. Being a partner in a U.S. partnership that conducts business here also counts, even without the partner setting foot in the country. Trading stocks or securities through a U.S. broker, by itself, does not create a U.S. trade or business.⁶

Some FDAP income crosses over to ECI. Under the asset-use test, the income must be tied to assets used in the U.S. business. Under the business-activities test, U.S. operations must be a material factor in producing the income. Gains from U.S. real estate are treated as ECI by statute in all cases.⁶

Treaty Relief and Form W-8BEN

The United States has income tax treaties with many countries, and those treaties often cut or eliminate the 30% withholding on dividends, interest, royalties, pensions, and pay for independent personal services. Many treaties also exempt business profits from U.S. tax entirely unless the foreign person operates through a permanent establishment in the country.¹¹

Treaty benefits have to be claimed. Individuals give the withholding agent a Form W-8BEN before payment, identifying the treaty country of residence and the specific article and rate. Form 8233 does the same job for compensation paid to independent contractors and certain employees.¹⁴ Without the right form on file, the payer withholds the full 30%, and recovering the excess means filing a return and waiting.

Filing as a Nonresident: Form 1040-NR

Nonresident aliens with U.S. source income generally file Form 1040-NR. The filing obligation applies to anyone engaged in a U.S. trade or business during the year, even without income from it, and to anyone who received U.S. source income for which the correct tax was not fully withheld. The return is due April 15 for those with wages subject to withholding, and June 15 for those without. Students and trainees on F, J, M, or Q visas who have no income taxable under Section 871 are not required to file. Filing is still worthwhile when withholding exceeded the actual liability, because that is the only way to claim the refund.¹⁵

1
Office of the Law Revision Counsel. 26 USC 861 – Income From Sources Within the United States
2
eCFR. 26 CFR 1.861-4 – Compensation for Labor or Personal Services
3
Office of the Law Revision Counsel. 26 USC 862 – Income From Sources Without the United States
4
Office of the Law Revision Counsel. 26 USC 871 – Tax on Nonresident Alien Individuals
5
eCFR. 26 CFR 1.871-10 – Election to Treat Real Property Income as Effectively Connected With US Business
6
Internal Revenue Service. Effectively Connected Income (ECI)
7
Office of the Law Revision Counsel. 26 USC 1445 – Withholding of Tax on Dispositions of United States Real Property Interests
8
Office of the Law Revision Counsel. 26 USC 865 – Source Rules for Personal Property Sales
9
Internal Revenue Service. The Taxation of Capital Gains of Nonresident Students, Scholars and Employees of Foreign Governments
10
Internal Revenue Service. Publication 519 – US Tax Guide for Aliens
11
Internal Revenue Service. Federal Income Tax Withholding and Reporting on Other Kinds of US Source Income Paid to Nonresident Aliens
12
Office of the Law Revision Counsel. 26 USC 117 – Qualified Scholarships
13
Internal Revenue Service. Partnership Withholding
14
Internal Revenue Service. Instructions for Form W-8BEN
15
Internal Revenue Service. Instructions for Form 1040-NR