Air-source heat pumps (ASHP) have been widely used for residential heating due to its energy-saving and high efficiency characteristics. However, the performance of an ASHP reduces as the ambient temperature decreases. In order to investigate the effect of ambient temperature on ASHP performance, an ASHP with an internal heat exchanger (IHX) using R404A as refrigerant was developed and studied at low ambient temperatures. The theoretical simulation was first performed to evaluate the performance of the ASHP with IHX and compared with three different cycles. The simulation results were validated by data available from literature and experimental data in this study. The results showed that the R404A ASHP system with IHX had a good potential for residential heating. Further investigation was performed to compare the performance of the R404A ASHP with and without IHX. The comparison results showed that the performance of the ASHP with IHX was far better than that of the ASHP without IHX. As the ambient temperature decreased from 0 °C and −26 °C, the improvement of the heating capacity of the R404A ASHP with IHX increased from 5.91% to 15.92% while the COP improvement increased from 10% to 20%. This indicated that the IHX technology became more and more effective as the ambient temperature dropped lower and lower.