Our house was built in the late 60's. We purchased it 3 years ago. The previous owners painted directly over the wallpapered living room. Not sure of their exact reasons for doing this, but it did not look good. Very visible wallpaper seams and sags in multiple locations, as well as paneling seams visible here and there. We thought the previous owners had told us they had tried to remove the wallpaper from the paneling and couldn't get it off. Last night we decided to try it ourselves in one section, and discovered that it is very easy to peel right off - at least in that area. Underneath is wood paneling. I dug behind the paneling in one location and discovered some type of sheetrock beneath it, and assumed it was drywall. I did see one seam and noticed that it wasn't taped or mudded. Since neither my wife or I like the paneling look and prefer drywall, we decided we'd tear down all of the paneling to expose the drywall, do the taping/mudding ourselves, and then paint when that's all done.

I should add that we are on a very tight budget.

Today, I started working on an entire section of paneling and quickly discovered one issue. The outlet boxes and door frame were installed to be flush with the paneling - not the sheetrock behind it. So if we proceed with this plan the outlet/light boxes will extend a bit in front of the drywall. Not sure how to solve that problem. Any suggestions? (Attaching one picture of this issue.)

After getting 90% of one section of paneling worked loose, I peeled it away from the wall enough to see behind it and discovered that the "drywall" is in 16" tall sections side-to-side. More importantly, I now noticed that the seams are not structured in a way to allow for the placement of a piece of tape. Meaning the edges don't dip in at all. (Attaching two pictures of this issue.)

What are our options for proceeding with this job? Option 1 obviously is leaving all of the paneling up, ripping down the wallpaper, and painting the paneling. Doable, but certainly not preferable.

If we remove the paneling, what then? Is it feasible to tape and mud sheetrock like this, keeping in mind how many seams there will be with 16" widths, and with no indentations for tape. If we can tape/mud it, how do we solve the outlet/light box problem? Would I need to open up the walls behind each box, remove the box, and re-nail it to the stud a little farther back?

Essentially, I'm wondering what our options are, and hoping to find a solution that will look very good without requiring a lot of cost.

Also, what exactly is on our walls behind the paneling? Is it drywall? Some type of papered plaster? Why 16" widths???