Well, in a last ditch effort to fully confirm the fate of the engine my mechanic did end up checking the thermostat, cooling fans, and pressure tested the cooling system. All those items checked out OK but then those tests may not be reliable (Thanks for the heads up, Rooster2.) In addition, they tested for hydrocarbons in the radiator and overflow tank (Thanks The Dude) and found them in both places in varying concentrations before and after test driving. Bummer.
I am currently considering my options: new (used/rebuilt) engine, insert a EJ22 SOHC engine, fix the HG and do any work on the heads, etc., or upgrading to a more recent Subaru. If we go with any sort of rebuilt or new engine I will insist on Subaru Original equipment parts. Luckily we still have my wife's 02 Outback sedan to get around in.
Upgrading to newer model has the distinct advantage of more comfortable seats, more and more appropriate cupholders (and other reasons) but it is hard to let go of a car you've known for 13+ years.