“Our plan would be to use it as a vacation home for a while and then sell it.What are the tax ramifications if we do this?”---->You can take advantage of the lower long-term capital gains tax rate since you owned it for more than one year .The your LTCG tax rate’d be 15 percent(0% as long as your tax bracket is lower than 25%) in 2012, according to the IRS. After 2012, the LTCG tax rate will be 20% (10%, NOT 0%, for taxpayers in the 15% tax bracket). If you make your vacation home your primary residence for at least two of the prior five years. Then, you do NOT pay capital gains tax on the first $250,000 in capital gains if you meet this requirement, according to the IRS. You can claim an exemption of up to $500,000 of capital gains if you meet this requirement and file your taxes jointly as a couple
“ If we do this in the middle of the year how does that affect the taxes?”--->As described above as long as you owned it for more than one year, your LTCG on sale of the vacation home ‘d be subject to LTCG tax.
“ What if, after a year or two, we decide to place it back in the rental program? “---->Then, your LTCG ‘d still be LTCG and I still subject to lower LTCG up to 2012 as aid above. If you expected loss (reduced by depreciation, which is carried over in your suspended losses) on the sale( I mean you sell at a loss )then th eloss will be treated as an ordinary loss (NOT LTCL) in the year that you sell the property. That loss will be a Section 1231 loss; Section 1231 losses can be used to reduce any type of income you may have - salary, bonus, self-employment income, capital gains, you name it. you may have a net operating loss (NOL) if the Section 1231 loss is large enough to reduce your other income below zero. If so, you can carry back the NOL for at least two years and use it to offset taxable income in those years. In doing so, you can recover some or all of the taxes you paid in those previous years by amending those returns. Losses from selling a personal residence(NOT as rental pty) are not deductible. I mean if you sell your vacation home at a loss as a personal residence, then you can never deduct the loss on your return. You can only claim tax losses for sales of property used for business or investment purposes. As long as your use it as rental pty and sell it then on the sale of the vacation home as rental pty, you must recapture depreciation. However, you sell it at a loss then you do not need to recapture depr.
“Is there an advantage to doing this before we sell it? What kind of taxes can we expect when we sell it?”---->As said above, as long as you dispose of the vacation as rental pty, your L:TCG ‘d be subject to lower LTCG tax rate, 10% or 0% and ALSO you do expect a tax loss from selling a rental property , a sec 1231 loss, then reduce any type of income you may have I mean you are NOT subject to passive activity loss / at risk rule.