Remax By the Water
I would not worry about the tax implications as much because it really washes out. If you take the loan, then yes you get a deduction, but you probably more than offset that deduction with capital gains, interest, or dividends.
It really comes down to the fact that you can get a loan at a pretty low rate and if you feel your investments could beat this rate, then you are better off investing the money and taking the loan. For a lot of people, I think they may believe that they can beat the interest rate on their investments, but it is not worth the risk.
If you need to downsize, find a home you can pay cash for and pay cash to do the repairs. Invest the rest and then invest the $1581.59/month (from $200k loan) payment. Your savings goes up in a hurry and you never have to worry about a house payment.