Don't know where to start, except to say that if you own a digital camera, take a pic of where the rag (WTF?!?!) made a hole in the case (then explain to me how a soft rag makes a hole in a hard engine case). It may be a small hole in the cover, or you might need a whole new bottom case. Without pics we can't tell ya what needs replacing.
As far as the burning oil thing, let's start in reverse. Clan the pipes out. 10 years of crap collecting in the pipe and then the pipe getting hot can cause all sorts of smoke. For all you know you could be barbecuing a dead mouse in each pipe, and let me tell you the fur smokes good. Stop mixing oil into the gas, marvel mystery oil is a good product for unsticking rings, etc, but it is not 2 stroke oil and this bike is not a two stroke, oh and by the way use fresh gasoline. If you are not seeing oil fouled plugs, chances are you are burning it else where.
If there is anything mechanical wrong causing the smoking my money is either on valve seals, or blow by. To check blow by do a leak down test (you will need compressed air or a bicycle pump to do this). After the pipes are cleaned and it still smokes you might as well pull the motor out and check the top end. Before you have to ask, the valve cover does not come off with the motor in the frame so yes you will have to pull the motor. 39K is a decent amount of miles so you probably want to check the valve train tolerances.
Clean the carbs and rebuild them, Use only the gaskets from a rebuild kit, keep the original hardware. Get the bike running under it's own power, 1st.
as for an engine swap, don't put the cart before the horse. At one point this bike was running fine, and then it got put away, try and get it back to it's pre-storage condition before you decide it needs to be replaced.
oh and fill out your bio and let us know your location, if there is someone close to you who can help out, that is 100 times better than words on a screen.