Need to clarify - the house is in ready-to-move-in condition. The house will need some cosmetic upgrades including the full bathroom (very small, 1960s/early 70s look to tub/shower, sink, counter, tile, etc). The owner bought at a higher price 2 years ago, did some work on the house (replaced siding, replaced roof and septic, removed overgrown bushes and trees, replaced some windows, added the woodstove and lined the chimney. He is very definitely losing money by selling, but he'd lose even more if he took another offer by another couple who want to rent-to-own. The house has only been on the market for 2 weeks.

But my husband and I feel that this is the house for our family and it likely has a better chance of being resold at a later date if we decide to upgrade altogether than the other properties on the market right now.

I always tell my clients it depends on how much they like the house. What are you wanting to pay. If you think it is over priced because of the kitchen then you should offer a little less, but if you are worried you may not get the house because of the lower price then this is the house you want. Then you should offer the asking price. What you must do is ask yourself "How bad do we want THIS house?" In the answer to that question is how you should put in your offer.

How do you know someone else wants to rent to own?
Next, where did the "valued at $204" come from and how long ago?
If you like the house, offer what you feel it is worth. If the seller doesn't like it, they can counter (or not).

Whatever you do, make sure you add that it has to appraise for that or you can walk; or bring cash, whatever you decide.

@acresofhome - thank you for the advice!

@roselvr - it was assessed (not appraised) at $204K, sorry, 2 years ago when the current owner bought it. Thanks for the advice as well.

We'll see how it all pans out!

The tax assessment can bear little relation to the actual market value. If you are working with a real estate agent ask for recent comps if possible to establish market value. Here are my thoughts. IF you say the kitchen is tiny and you want to make it bigger and redo it, you should expect to spend $50K. If you are going to redo the tiny kitchen but leeave the same layout, then the cost will be way lower such as 20K. I would allocate $10K for a basic bathroom remodel without changing the floor plan. The other thing to consider is certain things you may not be noticing today you may decide you don't like after moving in.
Having said all that, an actual purchase compared to a rent to own is way more attractive to the seller. I would start offering low, show that you have a mortgage preapproval, and negotiate to a final price between yourself and seller... if you cannot get to a price you think you are getting a great deal, then walk away.

Well, we made an offer - 97% of asking price - and he accepted! Woo hoo. Now the really hard part begins...