A vacation home or cabin can be a good investment, provide rental income and give you a major income tax deduction.

It can even turn into your year-round home after you retire.

A second home can be harder and more expensive to buy than a primary residence because lenders look at mortgage loans for second homes with a more critical and jaundiced eye.

But for many people, the benefits are definitely worth the trouble.

The National Association of Realtors says a record 1.07 million vacation homes were purchased in 2006, a 4.7% increase from 2005 and 14% of all homes purchased in 2006.

"The rise in vacation-home sales is based on strong demographic and lifestyle factors," says David Lereah, the Realtors Chief Economist.

"Baby boomers are at the optimum point in life when people become interested in second homes, they're at the peak of their earnings, interest rates remained low and they want to diversify investments."

NAR data shows the typical vacation-home buyer is 44 years old, earned $102,200 and purchased a property that was a median of 215 miles from their primary residence.

However, 42% of vacation homes were less than 100 miles from their first home, while 32% were located 500 miles or more from their primary residence.

When it comes to taxes, the IRS lets you treat a vacation home the same way you do your first home.

You can deduct the interest you pay on the mortgage for a second home just as you can for the first one. The IRS will actually let you write off the interest on two separate homes for up to combined total of $1 million in mortgage debt.

For instance, if you owe $750,000 on one and $250,000 on the other, you can write off all the interest payments. If, however, you owed $750,000 on both homes, for a total mortgage debt of $1.5 million, you could still write off the interest on the first $1 million but not on the remaining $500,000.

If you own three homes, you can write off the debt on only two of them, but you get to pick which two to deduct.

That tax deduction applies even if your vacation home is outside of the United States.

There will be more paperwork involved, of course, and you might even need to get the mortgage documents and records translated into English, but the IRS will allow the deduction as long as all you meet all the other criteria. For more information about that, you might want to visit the IRS' website at www.irs.gov.

If you rent out your vacation home for part of the year, the tax rules change but not the tax deduction.

The name of the deduction changes from personal mortgage interest to business expense. Many people with second homes use them as both income-generating and vacation properties, renting them out when they are not using them. If you do this, your tax preparer will figure out how much you can write off.

While the IRS treats both the primary and vacation homes the same tax-wise as far as the deductibility of interest paid (capital gains, however, are an entirely different matter) lenders do not.

Getting a lender to agree to loan you the money for a second home is more difficult because second homes are riskier. He or she knows that if times get tough, money is tight and you can't afford to pay two mortgage payments, odds are you will make the payment on your primary residence. After all, that's where you get your mail and your kids go to school.

That risk is one big reason why you'll pay a higher interest rate for a second home, usually a quarter to a half percentage point more than you would if you were buying a primary residence.

You'll also have to make a larger down payment than you would on a primary home, often 10% to 15% more than for a primary residence, because the lender wants to see a better loan-to-value ratio on a second home.

If you put less than 20% down, you will need private mortgage insurance (PMI), which also costs more for a second home than it does for a first one.

Lenders know that the more money you have invested in a home--your first or your second--the less likely you are to relinquish it to foreclosure. They figure that even if you do have to give it up, you will fight harder to keep it.

If your financial situation sours, the more money you have invested in the home, the harder you will try to sell it to get some cash out of it before handing the balance over to the lender.

When you buy a second home, you must also have a cleaner credit history, a higher credit score, and more discretionary income to qualify for that mortgage.

Buying a second home means you are committed to furnishing and maintaining it and paying the monthly utilities, taxes and all the other costs associated with home ownership. In some cases, your monthly housing expenses will double, and the lender will want to ensure you have enough income available to cover the increased costs.

The lender will also want to see a larger cash "reserve" for a vacation home. A lender who would be happy if you had two or three months' income tucked away when you buy a primary residence might want to make sure you have at least twice that reserve available when you buy a second home.

No one knows how much gasoline will cost next summer or how big of a fuel surcharge the airlines will tack on to each airline ticket.

But for millions of Americans, the advantages of a second home -- vacation destination, price appreciation, tax benefits and rental income -- far outweigh the costs and disadvantages.

After all, there really is no place like home--especially when you have two of them.

By Stef Donev

Interest.com Contributing Editor

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