I would like to understand what the potential impact of editing certain K2 xml files is when upgrading to a newer version of K2. (Note this question might apply to all other Joomla extensions in general)

For example, lets say I made an addition to the administrator/components/com_k2/models/item.xml file. If I upgraded to a newer version of K2 could it be possible that my changes are overwritten by the upgrade?

I understand that if I make changes to any php files in the /components/com_k2 directory that these can be overwritten. But does the same apply to xml files or css files such as k2.css? What about if they are in my template directory such as:

<joomla_root>/theme/html/com_k2/templates/MYNEWTEMPLATE

Can I assume that anything there will not be affected by an upgrade?

Extract a k2 to a local folder.
All the files in the directories there will be overwritten on upgrade.
YourSiteRoot/templates/YourTemplateName/html/......
is the proper place for overrides and they will not be overwritten when you upgrade k2
similarly you can override the k2 modules in the html dir of your template and they will survive upgrade
Any changes you make to the core files will be overwritten.
Do not uninstall K2 unless you want the k2 tables for categories, users, items, etc to be deleted

Even though your files still exist, there may be changes to the override files that need to be made. Keep check on the blog entries for the last few releases. There is a link to the override files and you can do a diff on them to see the changes