Where is the wallpaper folder in Windows 7?

They are in

• %SystemRoot%\Web\Wallpaper (default themes)
• %LOCALAPPDATA%\Microsoft\Windows\Themes ( any new themes that you might have installed )
• %APPDATA%\Microsoft\Windows\Themes ( any other pictures that you might have made as an wallpaper.

On my version of Windows 7 the Desktop Background folders are located in the directory below:

• C:\Windows\Web\Wallpaper

You can create your own folder, add it to the above directory, and then browse to that location to add it to the "Picture Location" dropdown list within the "Choose your desktop background" screen.