My plan is to continue to save for a down payment and in approx. ten months purchase my first home.

He is willing to pay the 20% down payment most banks would require, but I doubt a bank is going to want to touch this offer. 

Would you pay all cash for a sub 40k property, make a few minor repairs, and then rent it out for $500-$600 per month or would you use the 40k to make a 20% down payment and get a conventional mortgage on a much better property and rent it out at $950-$1050 per month?

Hey, as an owner occupant no big deal, I would of had a mortgage/rent payment anyway..

Payments are made through the towns lockbox service and those payments never come to her.This fine and dandy however I travelled to the address where the bill is sent and neither of the owners of record live there

They are fully rented (month to month) and gross ~$64000, with $17,000-$20,000 in annual expenses, before loan payments and management fees. 

In a lease option or subject to agreement, it is my understanding that I as the investor would pay the seller monthly payments.  

It isn't easy to find extra money for a down payment, at this point and so it kind of leaves us in an undesireable spot to be in.

I pay an introductory rate for the first two years, my current payment on 21k is 71.34 a month.

I want to refinance this property and take out the money to buy another rental property (or at least put a good down payment for one or two).