Sorry to hear about that BUT on the other hand, the car was FREE
It depends on how you look at it and what YOU really want to do. If the car runs well you don't neccessarily have to replace the WHOLE exhaust, all you have to do is have another cat installed. I live in Atlanta and Chicago so I can definately relate to the rust issues you may have there but again, this was a free car. I remember getting a "free" car from my mom (72 Grand Prix that's STILL in Chicago) when she was about to buy a new one (not to mention the motor was shot to hell) but me being a high school student just saw it as my first car, period.
I didn't have the $$ to do all of the repairs right then and there but gradually got her back together including rust repairs, interior, etc because I already visioned the finished car before it actually was. Just look at this car as a "project" if you will and if you decide that you'd like to take it on, YOU have to envision where you intend to take this car. There is a plethora of information that this forum's members can provide you as far as parts, advice,etc but the ultimate decision is yours.
If you decide to keep her, I would definately make sure she's running perfectly way before I'd worry about how she looks because ultimately it will be your cruiser. The 126 is one of the most classic Benzes but as you found out, with anything, if its not taken care of, it can be a b-tch! I don't know if you're a do-it-yourself-er, but the engines are one of the most user-friendly as far as engine work you may do yourself. I'd get another cat first (keep it simple for now to pass emmissions), Get your timing chain, guides, etc changed because I'm almost positive the previous owner didn't have this done and that is usually the only problem that can cause engine failure (because the guide rails are plastic and become brittle and can break in time, NOT that the chain fails).
You can then do the regular changes of the plugs (not platinums, but copper) wires, cap, rotor. I know where you can even get replacement fenders for ya if you decide to go that route in the future. Go with some seat covers (such as classy sheep skins) until you can get the seats repaired. I don't know if you had it checked out, but get the whole A/C checked for leaks,etc. (the person who I got one of my 560's from said the A/C was shot and all I've done was add the freon and she's blown ice cold for over a year). What plans if any did you even have for the car? If you were even wanting to sell it, I'm sure that one of my buds at home would buy it from you (but I can gaurantee that you'd be REEALLLY pissed off after you saw the finished product about 6 months later-- just ask the guy I got my 88 560 from!)