I don't see an signs of water ingress into the bellows, so I'm going to assume that folded up piece of rubber is an old sealing ring that's been pushed beyond the sealing face of the bell housing. You should be able to just pull it out without any resistance. If you feel resistance, STOP and investigate further. What I do see is what looks like salt deposits, and a rusty locking wire on the shift slide. I DON'T see a new style upper shift shaft seal carrier....
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This is the new style seal carrier I'm talking about.
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Merc revised the upper shift shaft seal situation after the original setup leaked all the time. The seal kept being burnt by exhaust gases. You need to remove the screw through the shift lever, then remove the lever and push the shaft down. Knock the old seal out, clean up the area and install the new carrier. I use a 6mm bolt, a bunch of washers and a nut as a driver tool. Once the new seal is in, clean up the shaft and refit it, and put the lever and screw back in. Unfortunately, the screw through the lever is Loctited in, and you can't always get it to come out. If it's stuck beyone removal, just hit the roller end of the lever and it breaks right along the screw line, take the bits out, pull the screw out of the lever and carry on. Obviously you'll need a new lever.. Don't try heating. There's a plastic washer under the lever and it'll melt and the whole job turns to sh*t.
Here's what the carrier looks like installed.
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Chris.........