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A water issue with a rain gutter has caused damage to my interior wall:

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How should I repair the damage in the process of preparing the wall for new wallpaper?

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How old is the house? Looks like that may have slats/plaster rather than drywall. Regardless, if it got wet, it needs to be replaced to prevent mold damage. Remove the trim, cut away the wall till you encounter no moisture.. most likely you'll have to replace the insulation as well, then put up some new drywall. Tape the edges, plaster, sand.. prime, then wallpaper. If you try to simply even it out, it probably won't be too long till the wall crumbles.

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