Well....I guess i would drain the lower unit oil first. Examine the magnetic plug for metal shavings. Examine the old oil for metal.
It is normal for the magnetic plug to have some fuzz of metal on it, but if you have mucho shavings, even big pieces, then you may as well plan on major gearcase problems, either a replace or rebuild.
Re-fill the gearcase before proceeding.
Even so, the water in the oil is a problem that must be addressed.
So, the next thing I would do is put it in the water on the trailer, or even just free floating, and remove the shift cable from the linkage. STBD side, the lower cable, one 3/8" nylock nut and washer, slip it off the pin it connects to. Then manually shift the gearcase, engine running, into both gears. What you are trying to determine is if the reverse is fine if you manually move the linkage to it's full travel. If you have good reverse by manually shifting it, and you have no shards in the oil, then it is likely OK, except that you have the water intrusion.
If it shifts into reverse and holds (no grinding or slipping) then the issue is with your shift cable adjustment.
At any rate, you will have to remove the gearcase, and pressure test it to determine where the leaking seal is. Possible areas for leakage are the propshaft seals, the driveshaft seals, and the shift rod seal. Immerse the gearcase in a tub of water, pressure it up, and watch for the bubbles.
Search here for gearcase pressure testing procedures.
If you are good mechanically, you can re-seal the gearcase for less than 75 bucks in seals....but it is kinda tricky doing the propshaft, simply because the carrier has to be pulled out. It can be done at home tho.