Part of the dream of living the good life is owning a second home. Your dream may be of a beachfront getaway, a ski lodge situated not far from your favorite runs, a cabin in the woods or a townhouse in the city.

"The advantage to a second home is basically the same as owning your principal residence," says Ronald J. Cappuccio, a tax attorney in New Jersey. "You'd also get your normal real estate [or property tax] deduction for the second home." That assumes that you stay in the home two weeks out of the year. The same is true, Cappuccio says, for third, fourth and fifth homes.

"The deduction is essentially limited to $1 million of mortgage and $100,000 of interest," he says. So if a person has inexpensive homes they might have multiple, and if you have expensive homes, then you're going to reach that limitation. That is one reason most people only designate two homes as their residence, treating the rest as a business investment by making them available for rent.

The rewards of renting
"If you rent it out for less than two weeks, then it's not considered a rental property," Cappuccio says. "However, that rent is still considered income and you have to report it as such." If, on the other hand, the house is rented out for at least 14 days a year, there are other tax advantages to be earned.

"If you have a rental property home down by the shore," he says, "and you use it for two weeks out of the year and the rest of the time it's rented then it's still considered an investment." "If a person has a home at the shore and they rent it out, they get depreciation on that." That's true, he says, even if the rental period is only a 10 or 12 week summer season.

Your investment in the building but not the land is deducted from your income as depreciation, even if the actual property value is rising. If 78 percent of the property tax assessment is for improvements, then you can write off 78 percent of the total costs for the property, including closing costs like title insurance and legal fees, divided over 31 years. But that is based on the fully loaded cost, not just what you have paid out. The depreciation and other business expense may be deductible even in a year when you don't actually receive any money from the house Cappuccio says.

"Let's say that one year you don't rent it out. You try to but it's too late and you can't rent it. Or, you rent it out but your costs exceed your income," he says. "Those deductions, as long as they do not exceed $25,000 per year, are deductible against the income for other purposes."

The IRS rules become more complicated if you stay in the home part of the time and rent it out at other times. Then, according to the IRS handbook on the subject, divide your expenses get divided between rental and personal use and there are some limitations. If it fits the IRS definition of a "dwelling unit used as a home," deductions for expenses cannot exceed the rental income.

Selling strategies
When people buy a vacation home, they often fall in love with it and imagine themselves holding on to it forever, perhaps even retiring to it one day. But circumstances change and, for all sorts of good reasons, they decide to sell. If it was an investment to begin with, then an eventual sale may be part of the exit strategy going in. Or changes in your family situation can make a change the right thing to do. Whatever the reason, thinking out the tax strategy can mean thousands of dollars staying with you or going to Uncle Sam.

If you sell the second home for a profit (as most people would hope to) the profits are taxed as capital gains-currently 15 percent, plus whatever the state's share is. But there are ways around that. If the home is your primary residence, the IRS lets you exempt $250,000 ($500,000 for couples) from the capital gains tax. To qualify, you have to have lived there for two of the last five years, whether you are living in the home at the time of the sale or not. But unless you are prepared to move into your vacation cottage for a couple of years, that is not much help.

1031 exchanges
There is an alternative that can, if not eliminate the tax altogether, at least defer it into the future, and possibly minimize it then. It is called a 1031 exchange, after section 1031(a)(3) of the federal tax code.

The 1031 Like-Kind Exchange rule only applies to business properties, so the first step is to convert your vacation home into a business property by renting it out for several months. Then when you sell it, you have six months to purchase another rental property, which can eventually be turned into a residence for your personal use. Capital gains taxes in 1031 exchanges are deferred until the second property is sold. These transactions are not a do-it-yourself proposition. There are any number of technicalities that have to be observed and the IRS requires that you hire a third-party administrator. The sale proceeds also have to be held by a bank trust department or a similar institution between the time the old property sells and the new one is bought.

Like everything related to taxes, these provisions are subject to change. Right now, according to Gay Oldham, president of Tax Consultants of Washington, the chairman of Congress's main tax-writing committee, the House Committee on Ways and Means, has proposed changes in the way interest deductions for second homes are treated so that only a percentage of the capital gains exemption would apply to second homes, depending on how long you used it as your primary residence.

For that reason among others, it is always advisable to talk to a tax professional about your particular circumstances before committing yourself to anything involving serious money.