We did a square reclining sectional because we didn't have a lot of room either. It adds that extra seating and is nice for lounging especially with a TV mounted high (that was our motivation for replacing our sofas). What about a chaise unit on the sectional on the end where the two chairs are now? The soft ottoman in one of the pictures is very nice. If you can update the fireplace you might consider taking out the base entirely--that will improve the flow since it looks like you have a lot of traffic. The fireplace would float a few inches on the wall like the photo in PatriciaHall's post.

Not sure, but can't you prime and paint over wallpaper? Make sure it's not peeling anywhere and if you need to add plaster of paris to the latex (homemade chalk paint which makes a great bond). My personal taste would be to swap out the art with something more personally meaningful - a gallery wall of impromptu photos of them and your kids artwork from over the years, perhaps? Especially as they are getting older, Just do some planning on frames/sizes and placement. There's a good article on Houzz.