In theory this works (the threshold the IRS has to prove a taxpayer is a dealer in securities, business interests, etc. is MUCH harder to prove than the threshold in real estate).

Acting as your own attorney is a bad idea, your agreement has issues in violation of IRS Code for residential property leases, you can't pay for maintenance or make improvements as the owner is required to capitalize and depreciate items and he's not expensing costs if you pay for them, doing so is tax fraud.

I probably would start with the cash offer and try to get the gap as narrow as possible before talking about sell financing.I would probably look up the IRS minimum interest rate for medium term loans and set something up with that as the basis for the financing.It also will depend on how much equity they have in the property whether it really is a viable option or not.

The borrower might risk the IRS coming in and forcing him to distribute his IRA and hit him with the taxes and penalties that come with the distribution.

After reading another post on BP (http://www.biggerpockets.com/blogs/6032/blog_posts/41751-you-likely-need-to-file-irs-form-3115-this-year---and-its-costly), I think it is time to get an accountant in my area who understands real estate so I don't end up making a costly mistake with the IRS.  

The following is from the IRS website, pay special attention to the last sentence."

@Grant Huggins The IRS language is as follows:  If a tax exempt entity engages in a trade or business on a regular or repeated basis, then UBIT applies.A single flip on rare occasion mixed into a portfolio of largely passive investments would not "likely" be subject to UBTI, with the caveat that the IRS has the final determination should they choose to take a closer look.  

As to that option price; 10% is the usual tipping point for residential option prices, the IRS has disguised sale limitations, some states have adopted foreclosure requirements for equity being established under any arrangement of an installment sale.

I received the following email earlier today from NAR reguarding the IRS wanting to eliminate 1031s.

As for other liens that survive, these can be: IRS-under special circumstances (under 120 day redemption period from deed recording).