(MONEY Magazine) – One of the big attractions of owning a vacation home--apart, of course, from being able to enjoy your own place at the beach, lake or mountains--is the ability to make money renting the place out. And then there's the hope of eventually selling at a profit. In the current hot real estate market a lot of people are feeling the lure. According to the National Association of Realtors, Americans own about 6.6 million vacation homes, and the number of people who say they've bought for investment reasons is growing.

The tax rules on vacation homes, though, can be tricky when it comes to renting them out and selling them. Particularly if you use the house some of the time and rent it out some of the time, it's important to know and plan for the possible tax consequences.

Generally, the Internal Revenue Service's regulations allow mom-and-pop landlords a few tax breaks, while simultaneously making it tough for rich people to use second homes as tax shelters. The result is a very complicated tax picture (or is that redundant?) that varies a lot depending on what your income is, how much you use the house yourself and how much you rent it out (see the chart on page 50).

If you own a vacation home and don't rent it out, the tax rules are simple. As far as the IRS is concerned, your vacation place is just like any other home, which means you can take deductions for mortgage interest and real estate taxes.

Plus you get a nice break: If you rent your house for 14 days or less, that rental income is exempt from taxes and need not even be reported to the IRS, which is how some people have made tax-free fortunes renting their homes out during conventions and big sporting events. "It is a freebie," says Jere Doyle, a senior director in Mellon Financial's private wealth management group.

RENTING YOUR HOUSE OUT

One rule of thumb about renting: If you limit your own use of a beach home that you also rent out, you'll get a bigger tax break out of it.

Keeping good records is essential. The tax advantage of renting out a second home lies in your ability to take a number of potentially large deductions, such as for brokers' commissions, repairs, and particularly depreciation on the property itself and on major appliances.

You can also deduct your mortgage interest and property taxes just as you can on a primary residence. If, however, you rent the house and use it yourself, the IRS will require you to split your mortgage interest and property taxes between Schedule E (the form for rental income and expenses) and Schedule A (the standard form for itemized deductions).

Your ability to realize tax losses from renting a vacation home is also restricted by your income. If you have adjusted gross income of up to $100,000, you may be able to claim as much as $25,000 in rental losses per year. The break phases out between $100,000 and $150,000. If your income is more than that, you can't take any tax losses immediately. Instead, you can roll them over from year to year and realize them when you sell the house.

SELLING A SECOND HOUSE

When you finally do get around to selling your retreat, you'll also need to calculate and pay tax on your capital gain. To do so, you'll increase your cost basis--and decrease your gain and your tax hit--by factoring in any improvements. If you've rented the house out, though, you'll also need to reduce your basis--and increase your gain--for the depreciation that you've been booking each year.

Say you bought a beachfront place in the Hamptons for $500,000 and booked a total of $100,000 in losses from depreciation while you owned it. Then you sell for $1 million. Your gain will be $600,000 ($500,000 taxed at the long-term capital-gains rate of 15% and $100,000 taxed at a special 25% rate for gains that shake out from depreciation). But there is also good news: You will be able to take that $100,000 in losses from depreciation against your taxable income, and that could significantly cut your tax bill, particularly if you happen to be in one of the higher brackets.