Yes, there is a diaphragm inside that somewhat seals the fluid from the air, otherwise the fluid would keep absorbing all the moisture out of the air, contaminating itself.
The master cylinder is the part that is at the lower end of the hose that comes out of the reservoir.
Usually, the only thing necessary on the reservoir is a good cleaning, unless it is physically damaged, then it needs to be replaced.
Any rebuilding" is going to happen in the master cylinder, where you will replace the piston, spring and seals.
You would probably be doing yourself a favor if you also got a rebuild kit for the caliper, but take it apart first, to see if you might also need to order a piston.
To answer your other questions:
Yes, you can get a new brake line from G&S Suzuki or any of the other vendors that we use.
A stainless line will also work, but is a bit more money.
Your issue with the brakes only working with the bolts loose is probably due to not having axle spacers installed correctly. If the spacers are not in the correct order, the brake disk will not be centered in the slot in the caliper, causing it to drag or bind. Find out which way the caliper needs to move, and how much, you will probably find a spacer that thick that you have in the wrong place.
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