First of all,
You don't have to remove the ads.
Once you apply for the custom domain to your blog, the ads would stop showing anyways. Just leave the ad code where it is.
Once your blog has the custom domain and you can get to your blog by using the custom domain url, then apply for the upgrade.
It's fine if it's still hosted on blogger. You just need the new domain.
To request an account upgrade you got to submit your custom domain once it's redirected to your blog.
See the instructions here:
It can take up to a few weeks or so to be reviewed and completed.
and select