bad transfer case?

ok i have a 94 with a 3.5 lift. no other mods to the driveline. out of no where i started getting a clunk from the transfer case around 10 mph and when i hit the brakes it gets much worse, clunking is in sequence with wheel speed. i removed rear driveshaft and clunk went away. i have replaced both u-joints. i jack up the vehicle and let it run in idle and it looks to be coming from the driveshaft into the transfer case. you can see the rust removed on the driveshaft and its sticking out about an inch and half or so. is this clunking solved by a t-case drop, extended driveshaft, or sye??? and if so than why did it just start clunking after about a year of driving on it?? or is this something in my t-case going bad?? thanks for the help