We purchased a home on 3.70 acres in Aug. 2005, for 412,000. Our
original plan was to subdivide two one-acre lots and pay down or off
the current mortgage of 330,000. We are now considering selling one
lot and the current home on it's own lot, and building on the other
lot. Would either of these have a greater financial benefit? Would we
have to pay the capital gains if the proceeds went directly to the
current mortgage?

There are some really savvy tax Researchers here, but in the end, you
are going to have to talk to a tax advisor you can shake hands with.
I am not one, but maybe when you subdivide the property, which the
mortgage holder will have to agree to, you can arrange for the
mortgage  - or maybe three, one on each new parcel -  to be valued to
limit your income on the parcels you sell.
I dunno, but a very interesting problem.