Seperate DAC or New AVR?

Save your money. Getting a new DAC will only run into the limitations of the existing AVR, and getting a new AVR with a budget of $500 would be a marginal improvement over the existing one at the very best.

Having said that, if you can find a used Pioneer VSX-D912, you may be in business.

http://www.audiocircle.com/index.php?topic=68889.0

I have listened to the 914, which is reputedly not as good as the 912, and even the 914 was markedly better than my Marantz HT receiver.

This is an interesting question regardless of price ($500 or $5,000). I think what it will come down to is room correction. I can tell you that when my DAC/preamp died, I started to run my music server (through a SPDIF converter) into my Integra Processor. To my surprise, the sound, once Audyssey corrected for room issues (despite the room being treated), was excellent. It may be audiophile sacrilege, but I am wondering if a very average processor with room correction could outperform a high end DAC in a non-perfect room. I am going to test this out over the holidays with Direc software and a borrowed DAC. It should be fun. If anyone has tried this already, please let me know.