Methanol also doesn't burn as hot, yes it gains more heat in the crankcase, cooling the crankcase, but it also burns at a much lower temperature.

You can heat the fuel and distill the alcohol. You can do this without gaining any appreciable amount of water, and if you pump out the air thus reducing the amount of heat added you will reduce the amount of water in the fuel. Nitro evaporates at a much higher temperature than the methanol so just keep the still well below the boiling point for nitromethane and you will only have a trace amount of nitromenthane.