I have been doing some research on customizing application.master. I found a good KB on Microsoft’s web site listing two ways to customize application.master.
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Customize the files in the Layouts folder (recommended)
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Create a custom Layouts folder
The two methods above work well.
I have been messing around with an application development method using a feature, HttpModule, and SPWebConfigModification. The premise of the feature is for every page, in the PreInit event, I check to see if the page’s current MasterPageFile is application.master. If it is, I set the MasterPageFile to my custom application.master. I plan on blogging on this method soon.

