Selecting the Right Photo

There’s nothing actually preventing you from using any photo you wish, but there are a few guidelines to follow if you want the effect to be somewhat realistic.

Avoid clouds/sky as much as possible. A “miniature” cloud tends to ruin the illusion Keep distances simple. Too many objects floating in and out of the background will make the effect very difficult to achieve. If possible, avoid large people and animals. It won’t look like a small scale photo if you can see Grandma on the porch.

For this guide, we’re using this source photo.

This particular image was chosen because it shows some of the potential good aspects, as well as some complications. Before explaining those in detail, let’s apply the basic effect and see what happens.

The Focus Blur

The idea here is that the area you wish to emphasize is at a certain distance from the camera, and objects at other distances are out of focus. In our example image, this is pretty simple to plan out. With the building at the far side of the water as our focal point, we can assume that everything above it (the sky) and everything below it (the nearby boats) would be out of focus.
Still with me? Ok, here’s how we make that happen. What we’re going to do is use 2 layers of the same image, one crisp and one blurry, and use a layer mask to fade between them. If you haven’t used layer masks before, now’s a great time to learn because they’re incredibly useful in many ways.
First, duplicate your layer so that you’ve got two identical shots.

With the top layer selected, go to Filters -> Blur -> Gaussian Blur. Precisely what you enter here depends entirely on your image and the distances involved. You may need to use the Undo button extensively before your image is done. For mine, I’m going with 15, which puts my image here.

Right now the entire top layer is blurry, and the bottom layer is nice and sharp. What we need is for the area we want sharp to show through clearly, while the other areas fade into blurriness the further they get from focus.

The Gradient

On the blurry layer, right-click and choose Add Layer Mask. When prompted, choose White – Full Opacity.

Layer masks are great – you can use them to “draw” transparency or other effects onto a layer. A fully white mask means that the layer is completely opaque, and nothing of the lower layers can be seen beneath it. Any dark spots drawn on the mask become “holes” in the layer, allowing the lower layers to show through. This means we draw a gradient on the mask, and as a result, the blurry layer can be faded in or out, allowing us to see the sharp layer beneath.
Since the focal point of our sample image is near the center of the picture, we’re going to use a bi-linear gradient. Unlike a normal “linear” gradient, it will follow the line you drag and it will mirror that line on the opposite side.

With black as foreground color and white as background, make sure you have the layer mask selected and not the layer itself. If colors and selection are ready, drag a line from the focal point to the area that should be fully blurred, as shown here.

This creates a black bar in your layer mask, which fades at the edges. This makes anything within the bar nice and sharp (showing the bottom layer) and anything else can gradually fuzzier (the top layer). Aren’t masks great?

The Hard Part

That’s about as far as we can go with “automatic” tools. From here on out, it’s doing fine-touches to the layer mask to make it look right. Take the above screenshot for example. You can see between the two buildings to the house and trees beyond. They’re nice and sharp even though they’re far away. Compare that to the boats which are only a few feet from our focal point, yet they’re blurry. The crane is another example of something that should be in focus, but isn’t.
Now, your only option is to sit down and start messing with that mask to make each piece pop just the way you want it.
For some fine examples of tilt shift done right, check out http://www.smashingmagazine.com/2008/11/16/beautiful-examples-of-tilt-shift-photography/.