Looks like mold and mildew. Is it the same stuff that is on the rest of the engine bay ? A good cleaning is in order. What concerns me the most is the oil injection lines. I would premix some fuel at 2oz per gallon to be safe in case one breaks or comes off during the test ride. At least it will have a fighting chance.
He was right not to run it more than a few seconds with no water. Basically just fire it up to make sure it starts.
Did you do a compression check ? Pretty mandatory. A worn engine will start and idle, and even run on the water if it's not to bad. If compression is good, your willing to do some preventive maint before using it, and the price is reflective of that, it might be a good deal. I've always liked the looks of the red GSX. I'm assuming it's the carbed GSX Limited ? That's a good engine. No rotory valve, just reeds.
I'm assuming the smoke you saw came from the expansion chamber clamp by the head in the picture ?
If it's the carbed engine, the carbs will need rebuilding before use also.