1. where should images be uploaded to? It really shouldn't matter, but if you put them in skin1/images it will make it easier to link to them.
2. what should be the HTML code to point to the image location? If you put your image in skin1/images it would be <img src="{$ImagesDir}/your_uploaded_image.jpg" alt="Your Uploaded Image" /> Otherwise it would be <img src="http://www.yourwebsite.com/the_folder_where_the_image_was_uploaded/your_uploaded_image.jpg" alt="Your Uploaded Image" />
Also, as balinor stated, you really should update your signature to include the version of x-cart you are using so that it will be easier for others to help you by knowing what version we are dealing with.