May I suggest a third option? Live with what you have now and keep an eye out for a nice, clean, well maintained W123 and use your white/blue/84/85/federal/cali cars for parts.....or sell the two as a combo to someone.
Repaint could be costly.

Not sure what your limitations are. I need more info to answer your poll.

Do you have space to hang onto a couple dead cars indefinitely?
Do you have the budget to maybe buy a nicer car?
Are you just itching to dive into a large project and have plenty of time to work out the headaches as they pop up?
Do you have the patience to do this?
Do you have help to swap the motor/trans?

I do not know what problems would arise installing a non-smog motor into a smog-car. I would assume though that since you have 2 complete cars, that you could just shy of swap everything.

If you are throwing practicality out the window and boldly jumping head first into an adventure, I would always start with the clean chassis, everything else just bolts on. Making a 'bent' car straight takes much time and patience, then 1000-4000$ worth of paint and prep depending upon your intended level of quality. If one car is clean and not in need of paint, go with that one.

I still say, leave it alone (fix the motor), and keep an eye out for a clean car.

have fun.

__________________
85 300D 3 pedal. Current project.
83 300TD (need rear wiper assembly dead or alive)
84 300SD Daily driver
85 300TD almost 400k miles and driven daily.
98 E300D *sold
86 300SDL *sold and made flawless 10 hour journey to new home.