About negative energies: they set no problem:
On this context, only energy differences have significance. Negative energy appears because when you've made the integration, you've set one point where you set your energy to 0. In this case, you have chosen that $PE_1 = 0$ for $r = \infty$. If you've set $PE_1 = 1000$ at $r = \infty$, the energy was positive for some r.
However, the minus sign is important, as it is telling you that the test particle is losing potential energy when moving to $r = 0$, this is true because it is accelerating, causing an increase in $KE$:
let's calculate the $\Delta PE_1$ for a particle moving in direction of $r = 0$: $r_i = 10$ and $r_f = 1$:
$\Delta PE_1 = PE_f - PE_i = Gm(-1 - (-0.1)) = -Gm\times0.9 < 0$
as expected: we lose $PE$ and win $KE$.
Second bullet: yes, you are right. However, it is only true IF they are point particles: has they normally have a definite radius, they collide when $r = r_1 + r_2$, causing an elastic or inelastic collision.
Third bullet: you are right with $PE_2 = mgh$, however, again, you are choosing a given referential: you are assuming $PE_2 = 0$ for $y = 0$, which, on the previous notation, means that you were setting $PE_1 = 0$ for $ r = r_{earth}$.
The most important difference now is that you are saying that an increase in h is moving farther in r (if you are higher, you are farther from the Earth center).
By making the analogy to the previous problem, imagine you want to obtain the $\Delta PE_2$. In this case, you begin at $h_i = 10$ and you want move to $h_f = 1$ (moving in direction to Earth center, like $\Delta PE_1$:
$\Delta PE_2 = PE_{f} - PE_{i} = 1mg - 10mg = -9mg < 0$.
As expected, because we are falling, we are losing $PE$ and winning $KE$, the same result has $PE_1$
Fourth bullet: they both represent the same thing. The difference is that $gh$ is the first term in the Taylor series of the expansion of $PE_1$ near $r = r_{Earth}$. As exercise, try to expand $PE_1(r)$ in a taylor series, and show that the linear term is:
$PE_1 = a + \frac{Gm(r-r_{earth})}{r_{earth}^2}$.
Them numerically calculate $Gm/r_{earth}^2$ (remember that $m=m_{earth}$). If you haven't made this already, I guess you will be surprised.
So, from what I understood, your logic is totally correct, apart from two key points:
energy is defined apart of a constant value.
in the $PE_1$, increase r means decrease $1/r$, which means increase $PE_2 = -Gm/r$. In $PE_2$, increase h means increase $PE_2=mgh$.
First things first: the total mechanical energy is always kinetic energy plus potential energy. So if your answer sheet actually said $KE - PE$, it's wrong. But what I suspect it really said is that the potential energy is negative, so the formula you wind up with is
$$\underbrace{\frac{1}{2}mv^2}_{KE} \underbrace{- \frac{Gm_1 m_2}{r}}_{PE}$$
Now, the negative sign doesn't mean that you're losing energy. It just means that the amount of energy happens to be less than zero.
Consider this: the formula that works on the Earth's surface, $PE = mgh$, makes sense, right? It seems intuitive that potential energy should get larger as you go higher above Earth, because you have to put energy into something to raise it up, and when it's higher it has more potential to do work by falling. That same principle should hold for the general $1/r$-type formula: the potential energy should get larger the higher you go. But at larger values of $r$, the reciprocal of $r$ gets smaller, which is the wrong trend. The easy fix is to make it negative. And the math works out to support that.
Best Answer
First of all, you wrote the equation for $U$ wrong; it should be $r$ instead of $r^2$ in the denominator. However, that typo isn't what the problem is.
The problem is that you've overlooked the word "magnitude" in the question. If a negative number is changed to be a different negative number that's closer to zero, then the magnitude of the number has decreased, even though the number itself has increased.
Potential energy does indeed increase as you lift a pen further away from a table, and potential energy does indeed decrease if you drop the pen.