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While I think you can install it on the Skull Rock Island at Dazzle Beach, it should work anywhere along the shore of the beach. You could probably even put it in the swamp water area. That is where I put Ursula's house. It seems to fit there to me.
Like all the houses in the game, there is no "designated" spot for it, you can place it anywhere you like. Mine is in the water just to the left of Donald's ship, close enough to shore that I can easily enter the house without having to track Ariel down and use the "Let's visit your house" dialog option to get there. I personally think it looks better in the water than on land, but that's just personal preference. BTW, I wouldn't place any house on the island in front of Skull Rock because you'll eventually have to place some specific items there when you're near the end of the current storyline. (Don't want to spoil it in case you haven't gotten there yet.)