As far as I know, when you substitute something, you replace something. the word 'crackpot' and replace it with the word 'infested'. doesn't make any sense, so I'd go with your first option: 1.
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I advised him to take out the word 'crackpot' and substitute the word 'infested'.
What does it mean? Does this sentence mean that ( A ) I advised someone to take out the word 'crackpot' and substitute the word 'infested' for some other word (abound, for one)? Or does it mean that ( B ) I advised someone to substitute the word 'crackpot' for 'infested' (it makes no sense, th