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I just put a windshield in a "car of a different color" and used black pinstripe tape to hide the yellow showing from the old seal.

I've seen this occasionally. The exhaust gives a puff of smoke when started cold. The car isn't moving and therefore sitting in it's own puff of smoke. Some gets sucked into the fan where it ends up in your heater. I saw this in my '74 often and occasionall in the '71. Bet it doesn't happen on a windy day !

Any later model motor will work but the column switch years require some clever reworking to get working properly.
The best year I've found was '71 it is a late model motor but still used the two speed dash switch. The tech guys will tell you it will not fot without drilling the wiper shaft holes bigger. All you need to do is cut a new wiper shaft seal in half so you have the inner and outer half (two complete rings) trim them so they are flat and slip one down the shaft before installation of they assy (inner seal), install the assy then slip the outer seal on, washer and nut. You can even use the nice outer plastic nut cover. Use two late model right side wiper arms (they are clearly marked R & L on the face of the arm near the base) unless you want the left one to stand up at an angle like the later cars do. I paint the arms the proper silver and even take the rubber out of the blades to paint the blade holders silver too like they should be. If you use a 71 dash switch you may have to open the hole up and use the 71 nut (polish it 1st) but the original knob & button will work fine. A '67 dash switch or original single speed switch works too. The only think left would be to make a small modification to the upper motor mount under the cowl where there is a small tab and 8mm bolt.

You beat me too it Yancy. Compression test is useless unless the valves have been properly adjusted.

Mexi seals do not fit across the top of the hood. Only the entire sides & front where they meet an original looking curved seal at the corner and the original seal across the top. VW's adjustment for an XS gap across the top was to bent the cowl up slightly using a "local manufacture" tool which at the dealer basically meant whatever you could get your hands on. I find that in leiu of bending the cowl, sometimes if the gap isnt too bad a 1/2" wide roll of closed cell foam like your front door uses works if stuck under the lip of the lid.

Funny !  In the 15 years I drove my 74 with the bilge pump fans I had to replace the foot well vents up front 4 - 5 times as they would distort from the heat and not close properly. I would routenely melt the plastic trim "donuts" in the rear footwells and finally left them off.

I can'r open your pictures but am looking for a functional 12v gas heater for my '62