Cyanogen Mod version 7 allowed up to about 1GB. Area51 Forum had a few Gingerbread ROMs that allowed at least 2GB (that was the largest card I had available at the time). It mounts the SD card as "internal storage", so the ROM and all your apps, app data, etc., are on the SD card. The internal storage - IIRC - just wasn't mounted, it was ignored. It would take a while to pop an 8GB card into my old Precedent (the batteries - all 3 of them are still fine), flash the ROM and see if I could allocate more than 2GB, but it would probably work. Try it. If the phone gets weird with more than 2GB, make a 2GB partition on the card and use that. It's a lot more than the original. I usually ran with about 1.2GB free storage space.
(If you mess up the installation, the guys are still there to help you (DroidHost knows what he's doing, and wrote the Precedent ROMs) and the live chat is available if there's someone there.)
Just rooting a device does nothing except give you more control over the device. A rooted device that hasn't been modified at all acts no differently from an unrooted device.