I would argue that the core issue around this article is not the occupations of Gaza and the West Bank. For one, while Israel has tremendous control over the Gaza region, it is self governed and not occupied by Israel--that's semantics, but I do want to make the distinction between the level of autonomy Gaza has versus the level the West Bank has.
I agree with the two options you put forwards, and I personally prefer the latter. I think the only path to peace in Israel is to end the occupation, make peace with Gaza, move the capital to Tel Aviv, and establish Jerusalem as a U.N. Mandate. I don't think Israel has a valid claim to exclusive control over what many groups consider the holiest place on earth, but I also don't think other groups who consider it a holy place should have exclusive control over it either. Putting the U.N. in control of it is an imperfect solution, but better than what we have now for peace in the region. That's my two cents that no one asked for.
The last move in that direction - the retreat of Israel from Gaza, brought Hamas to power . Whether there's ever peace doesn't solely depend on Israel. Israel is actually not a very important piece of the puzzle imo, most Israelis know very well peace is in their best interest. There's just not many buyers on the other side.
You start off saying that it's 'disgusting' to call Israel a racist state and then conclude by saying that it was always intended to be a 'Jewish state' and not a 'melting pot'. That's highly contradictory and defending a very racist policy, which is indeed, disgusting.