Basics:
Me H1-B entire 2008
Spouse H4 January - August 2008, leaving US permanently (H4 terminated) since September 2008, earned income in Hong Kong September - December 2008 about $60K

Question:
1. Can we married file separately to avoid the tax on my spouse's income earned in Hong Kong?
2. If married file separately, does my spouse need to report the $60K income made in Hong Kong to IRS? I think it is not US source income at all. There's no US income made in 2008.

Is there any other better alternatives? Please advise. Thanks!

Anyone knows the answer?

Yes, it seems best under the circumstances to file separately.

No, there is no need to report the Hong Kong income on the 1040NR since it is not effectively connected to a US trade or business.

Thanks, Five Rings! Are you sure my husband can file 1040NR? He's been in the US for moe than 183 days in 2008, should he file 1040 instead?

He is a dual status alien, last year of residency.

Read all about it in Publication 519
Publication 519 (2007), U.S. Tax Guide for Aliens (http://www.irs.gov/publications/p519/index.html)

Thanks again, Five Rings! I now read pub.159 on last year of residency. It says the residency terminates on the day my spouse left US.

Does it mean my spouse needs to file 1040 for Jan - Sep and 1040NR for Sep - Dec? Or one 1040NR is fine.

From Publication 519:

Nonresident at end of year. You must file Form 1040NR or Form 1040NR-EZ if you are a dual-status taxpayer who gives up residence in the United States during the year and who is not a U.S. resident on the last day of the tax year. Write “Dual-Status Return” across the top of the return. Attach a statement to your return to show the income for the part of the year you are a resident. You can use Form 1040 as the statement, but be sure to mark “Dual-Status Statement” across the top.