@Paul Allen , We see a lot of that exact strategy down here. Their plan is perfectly fine. A two year period as a full time rental of their replacement property would satisfy the IRS safe harbor.
Simply converting the property by moving in after that period would not trigger a gain recognition by itself. Once they are ready to sell that property after a period of years they will have some restrictions on the amount of tax free gain they will get.
1. In order to sell it and get a portion of the gain tax free when they eventually sell they will have to have owned it for at least 5 years because it was originally the product of a 1031 exchange.
2. They will have to have lived in it for 2 out of the five years prior to its sale in order to qualify it for the 121 exemption.
3. They will have to recapture depreciation during the time it was a rental.
4. When they do sell they will have to prorate the gain between the periods of qualified use (as their primary) and non-qualified use (when it was a rental).
So if they did a 1031 into a nice FL rental and used it as rental for 2 years and then moved in and lived in it for 3 years they could sell and take 3/5ths of the gain tax free up to the limits of sec 121 after they recapture depreciation.
It's not the total windfall it was in the early 2000s but it's still a great opportunity to mitigate some of the pent up gain from 1031ing over the years as a retirement strategy.