Sales of existing homes picked up in 17 states in the first quarter compared with the previous one, pointing to more signs of life for the home market.

Nationally, first-quarter sales of existing homes were down 3.2% from the last three months of 2008 and down 6.8% year-over-year, the National Association of Realtors said Tuesday.

But the improvement in 17 states is more evidence that the market is bottoming out, economists say. In the fourth quarter, only nine states showed better sales. Economists predict more states will show sales gains throughout the year, given still falling prices in many markets, low mortgage rates and some signs of improvement in the overall economy.

“There are early signs of recovery in some states. They give me reason for optimism,” says Patrick Newport, economist at IHS Global Insight. He expects home sales to pick up nationwide in the later part of this year.

The pace of the pickup this year may “surprise to the upside,” says Greg McBride, senior financial analyst at Bankrate.com. That’s because prices have dropped so much that more people can afford homes, he says.

That trend continued in the first quarter. Single-family home prices declined year-over-year in 134 of 152 metropolitan areas, NAR says. Nationwide, the median sales price for a single-family home was $169,000, down 13.8% from the same quarter a year ago. Median means half sold for more and half sold for less.

Median prices are skewed downward by the number of foreclosed and distressed homes being sold. They’re selling for 20% less than traditional homes and account for about half of all sales, NAR says.

That’s attracting many first-time buyers, who accounted for about half of the quarter’s sales, NAR says.

Low prices driven by sales of foreclosed and distressed homes helped Minnesota post a 12% gain in the first quarter compared with the same period a year ago, NAR says. Median prices there are at 1997 levels, says Christopher Galler, chief operating officer of the Minnesota Association of Realtors. He says foreclosures and short sales in which banks forgive some of what is owed account for 50% of transactions.

That’s also true nationwide, NAR says. The glut of distressed homes on the market will continue to be a “drag on prices,” McBride says.

The states with the largest sales gains from the fourth quarter were: Wyoming, 44%; Alaska, 37%; Nevada, 25%; and Minnesota, 22%. The figures include single-family homes, condos and co-ops.

A shrinking economy and frozen credit markets are a lethal combination for real estate investment trusts. The Dow Jones Wilshire REIT index lost 34% over the past year through February 6, as investors concluded that these toxic conditions would force many REITs to pare back generous common stock dividends. REIT preferred shares did just as poorly.

Nevertheless, preferred issues from some of the stronger players are worth a look. They yield 9% to 12%, and their dividends are shielded by an added layer of protection: A REIT would have to eliminate its common dividend before it could reduce its preferred payout. “The reality is that most REITs aren’t even going to cut their common dividend,” says Jay Leupp, who runs Grubb & Ellis AGA Realty Income fund and invests 80% of its assets in REIT preferreds.

REITs own a variety of property types and usually pay out almost all of their profits as dividends. While the holders of common stock can expect rising dividends and share prices during good times, preferred investors settle for safer, bond like returns. Preferreds pay a fixed dividend, and the share price (typically $25 when the stock is issued) normally moves in response to, and in the opposite direction of, interest rates.

But in 2008, preferred shares collapsed, even as rates sank. Among the causes: forced selling by troubled hedge funds and closed end funds, fears that a recession would drastically reduce REIT profits, and concerns that REITs would be unable to refinance loans and be forced to sell properties at fire sale prices.

As a result, the average yield of REIT preferreds is almost 11 percentage points higher than that of the ten year Treasury note (recently 3.1%). That’s well above the historical spread of four percentage points, according to Kensington Investment Group, an Orinda, Cal., money manager.

Some issues may also offer a rare opportunity for price gains. Preferreds are usually callable, which means issuers can buy them back at the original face value after five years. For many issues, that would represent a gain over current price levels. More likely, issuers would use extra cash to buy shares in the open market. Either strategy could push up prices. On the downside, REIT dividends are taxable at rates as high as 35%, so the shares are best held in tax deferred accounts.

Three good choices. You can buy REIT preferreds through most brokers. Begin your research at QuantumOnline.com, a free web site. Look for issues, such as the three described below, from well established REITs with relatively low debt levels. (Symbols are for common shares; preferred symbols vary according to the source.)

Series E shares of PUBLIC STORAGE (SYMBOL PSA) pay $1.69 in dividends annually, resulting in a 9% yield at the recent price of $19. Leupp calls Public Storage, which is the world’s largest provider of self storage facilities and has minimal long-term debt, the “gold standard” of REIT preferreds.

PS BUSINESS PARKS (PSB), which was spun out of Public Storage in 1998, owns industrial, office and retail business parks. Its low debt and $60 million cash cushion make it a safe holding despite its exposure to the struggling office and retail sectors. Series L preferred shares pay $1.90 annually and yield 11% at the recent share price of $18.

HCP (HCP) owns a mix of recession resistant senior housing facilities, hospitals and medical office buildings. Its series F preferred shares pay $1.78 annually. At a share price of $17, that’s a yield of 10%.

Whether you use your vacation getaway every weekend or just a few times a year, you may want to rent It out occasionally to offset some of your expenses. That’s fine, as long as you don’t set off any alarms with the internal Revenue Service.

1. If you rent out your house for 14 days or fewer during the year, you don’t have to report the rental income on your tax return. And there’s no limit to how much you can charge. The house is considered a personal residence so you deduct mortgage interest and property taxes just as you do for your primary home.

2. If you rent out your house for more than 14 days, you become a landlord in the eyes of the IRS. That means you have to report your rental income. But it also means you can deduct rental expenses. It can get complicated because you need to allocate costs between the time the property Is used for personal purposes and the time it is rented.

3. If you use the place for more than 14 days or more than 10% of the number of days It is rented whichever is greater it is considered a personal residence. You can deduct rental expenses up to the level of rental income. But you can’t deduct losses.

4. The definition of “personal use” days is fairly broad. They may include any days you or a family member use the house (even if the family member Is paying rent). Personal days also include days on which you have donated use of the house say, to a charity auction or have rented it out for less than fair market value.

5. If you limit your personal use to 14 days or 10% of the time the vacation home is rented, it is considered a business. You can deduct expenses and, depending on your income, you may be able to deduct up to $25,000 In losses each year. That’s why many vacation homeowners hold down leisure use and spend tots of time “maintaining” the property; fix up days don’t count as personal use.