Hi Stoney
Two of my three CMPs have had water in the transmission, I think it gets around the shift lever particularly around the reverse lock out rod. One old Chevy GMC guy told me to pack the rod area with grease and grease the ball area once a year, he suggest removing the lever to do this. I've added doing the same to the transfer chase lever assembly.
Now as to water damage to the gears and bearings, take a look at
http://canadianmilitarypattern.com/C...ansmission.htm which is old thread from MLU with more pictures added. (some of the pictures are high resolution and large so maybe slow downloading.) My C60S had some really nasty stuff in the transmission. Looked like brown 3 layer jello and about the same consistency when I first got the truck. Completely disassembled and cleaned the transmission and as you can see from the photos there is some gear tooth pitting and one of the shafts developed a chatter after 10 years of use. But now with 20+ years of driving it still shifts good.
Now about the "the transfer case selector shaft is pretty corroded" I assume you mean the tower assembly, or do you mean the shift shafts that actually go into the transfer case.
Think you will be happy with the 261 engine, the 261 engine in my C60S with radio box makes it a very enjoyable truck to drive.
Cheers Phil