You are better off unless you bought the large house for cash. Otherwise, you made a big gain in leveraged terms.

What you say is true, but it misses the point, which is that big gains only help you if you actually cash out. If you're making a lateral move, or downsizing in the same area, it doesn't matter whether you're leveraged or not. A loss is still a loss.

The example is useful, thanks. I see that there's $125k of cap gains to pay for a move to a property of the same price. You're calling that a loss though, and I'm not sure I see it that way. Sure, if house prices hadn't gone up you could have moved from a $1M house to another $1M house and paid nothing. But in your example you're still $875k "in profit", so it's not really a loss, it's just a cost associated with a lateral move in the same area. If you downsize you actually realize some of those gains - of course not all of them because tax must be paid, but there's no avoiding taxes :)