They look at how much entitlement you already used based on the purchase price of home #1 and then follow the guidelines as spelled out here: http://benefits.va.gov/homeloans/purchaseco_loan_limits.asp
I was in your situation last year and opted for another VA loan. Depending on the price of the home you're looking at, you may have to make a down payment anyway (the VA only guarantees up to $417K, so if you have a higher priced home, or your first home ate a considerable amount of your entitlement, then you will have to cover part of the difference). I don't know what the tax law will be next year, but we were able to deduct the VA funding fee, which was beneficial.