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Flush it aggressively to get any sediment out, and I don't mean fill, heat cycle, dump; I mean put the hose to it with the drain pulled and run some FLOW though it. Next, optionally, run a treatment option of your choice, dilute vinegar and time, commercial radiator flush, CLR if you wanna go REALLY aggressive, etc. Once done, put distilled water in it, use a track safe/legal additive package like Cool-Aide/etc as a corrosion inhibitor, and change the water more frequently going forward.
Not a good idea as it will only continue the issue. You don't want any tap water going into a cooling system, ever.
Yes, the distilled water will dilute the tap water but the iron (and other minerals) are still present in the tap water regardless of dilution. There will still be a reaction within the cooling system.