Do I use a Krell HTS 7.1 or a DAC????HELP......

Well, having the home theatre option is certainly nice, Matt. Whether or not the HTS will outperform a standalone DAC depends of course on which DAC you buy. My suggestion to you would be to replace the Yamaha with a better disc player. The Yamaha is an okay CD player at best, and honestly not up to the quality of your other components, unless Yamaha produced some rare esoteric CD player that I'm not aware of. Judging from how you describe the sound of your system ,I'm guessing, not. You didn't mention the model number. Sell the Yamaha, and add, that money to what you would have to spend for a used HTS and you should be able to find a very good used CD player.Some suggestions would be a Rega Planet, or a NAD Master series M5, with SACD as a bonus. I'm sure some others will have many more possibilities for you to consider.

Instead of HTS7.1 get the HTS2 (the 5.1 version prior to the 7.1). The HTS2 sounds far better in 2-channel snalog using preamp mode. I never found the 400xi to have any weight/body in the sound, seemed to bright and a bit shrill. Ofcourse, a change in CD player will also help. But as you said, the HTS2 will give option of theater also.

The 400xi Has excellent bass and a fantastic sound stage not shrill at all very musical. It was the 300il that sounded shrill and not very engaging.

Anyway, I thought that the HTS 7.1 sounded better than the HTS2? In 2-channel set-up?

I have the same amp, 400xi, and use a Benchmark DAC1 with excellent results. Speakers are Focal Utopia Be's.

As a transport I'm using a Krell DVD standard, but any spinner would work, including your Yamaha.

Additionally, the DAC1 has multiple digital inputs which allow you to use it as a digital preamp of sorts. Mine uses optical from the computer and coax from the DVD Standard.

Be sure to use the balanced inputs on the 400xi.