This is not exactly right.
For the Display Properties Background tab, Windows XP fetches the image files from the following locations:
BMP Files from %Systemroot% folder.
BMP, JPG, GIF, JPE, DIB, PNG, HTM files from the following locations:
%Systemroot%\Web\Wallpaper
%USERPROFILE%\My Documents\My Pictures (& sub-folders)
%AppData%\Microsoft\Internet Explorer
%ProgramFiles%\Plus!\Themes (& sub-folders)
If you want to clear a file from the background tab listing, move the file away from the above mentioned locations. To access each of the folders above, type the Path in Start, Run dialog box.
Note: Using Environmental variables
%Systemroot% represents the folder where Windows is installed.
%USERPROFILE% represents the user profile home path
%AppData% represents the Application Data folder path
%ProgramFiles% represents the Program Files folder
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