And points paid on a loan secured by a second home or vacation residence, regardless of how the cash is used, must be amortized over the life of the loan.

Taxes

A big part of most monthly loan payments is taxes, which go into an escrow account for payment once a year. This amount should be included on the annual statement you get from your lender, along with your loan interest information. These taxes will be an annual deduction as long as you own your home.

But if this is your first tax year in your house, dig out the settlement sheet you got at closing to find additional tax payment data. When the property was transferred from the seller to you, the year's tax payments were divided so that each of you paid the taxes for that portion of the tax year during which you owned the home. Your share of these taxes is fully deductible.

A word of caution: If your settlement statement shows any money you paid into an escrow account for future taxes, this amount is not deductible. You can only deduct the taxes in the year your lender actually pays them to the property tax collector.

For example, you bought your house on July 1. Your property taxes are due each Jan. 1. When you closed, the seller had already paid the year's taxes of $1,000 in full so you reimburse the seller half of his annual tax payment to cover your ownership of the property for the last six months of the year. Your $500 reimbursement to the seller is shown on your settlement documents.

The closing document also shows you prepaid another $500 to the lender as escrow for the coming year's taxes due next Jan. 1. The $500 you reimbursed the seller at closing is deductible on this year's tax return, but the $500 held in escrow is not deductible until it is paid the next year.

When you sell

Years ago, to avoid paying tax on the sale of a residence a homeowner had to use the sale proceeds to buy another house. In 1997, the law was changed so that up to $250,000 in sales gain ($500,000 for married joint filers) is tax-free as long as the homeowner owned the property for two years and lived in it for two of the five years before the sale.

If you sell before meeting the ownership and residency requirements, you owe tax on any profit. The IRS provides some tax relief if the sale is because of a change in the owner's health, employment or unforeseen circumstances. In these cases, the tax-free gain amount is prorated.