My 1999 Impreza has a bad rust issue around the rear wheel wells.. Since it will not now pass state inspection, I must either fix this problem, sell the car, or buy a comparable car with a blown engine, and do a engine swap. Any input would be great. It runs great with cold a/c!

Everyone in Northern US has this problem with 90's subarus.  I'm surprised that it is a problem as far South as Virginia but they must use a lot of droad salt down there.

 

The corrective action is as follows:

 

1.  Cut out the rusted paneling.  You have to cut back at least an inch from the edge of the rusted hole.

2.  Fiberglass over the hole.

3.  Layer Bondo over the fiberglass to smooth the surface.

4.  Paint it.

 

Of course, there are more details involved, but the above is the general idea.  Your friendly auto parts store will be happy to sell you all the supplies necessary.  And the rust can be more serious then just a hole in the sheet metal, which would make the repair more difficult. 

pics would help. If it's just the rear quarter panel and nothing structural the above mentioned fix or similar is the way to go. You can weld in new tin. Fiberglass, bondo or the redneck fix of expanding foam and roof flashing.

 

Unless you have severe rust where the structure is compromised, its simple and easy to do a few patch jobs to keep the car on the road for a number of more years,