There are rational decisions, and then the ones people make...they don't always match up.  

For the property owner it may seem like the rational thing to do.  

Looking for the following criteria:- best Interest Rate-Ease of requirements (min down payment, debt to income ration, etc.)

Only for those individuals may there be a suspension of the 5 year look back to allow an additional 10 years.There is no general automatic pro-ration after the 5 year period.  

We've worked with may clients who will move out of a primary residence that has more than 500K in gain so they can combine sec 121 and 1031 to make all of the gain tax free or tax deferred.We've also have numbers of clients take advantage of the 1301 - 121 conversion to ultimately turn part of the tax deferred gain into tax free.Your situation is somewhat unique in that you're wanting to combine both of those strategies and take the 121 pro-ration tax free and 1031 the other pro-rated gain.

Doesn't make rational economic sense. 

I don't have the experience to know if new furnace/water heater/windows/appliances would alter the appraised value to make this a rational deal under these circumstances.

If we have a 100 year history of commodity prices hovering within a certain level and a current price 70% above the historic baseline, it means that the market for this commodity is not rational in any way, shape or form.

Hopefully, your "fair share of horror stories" will help keep you rational.

If they were provided a list that said they didn't leave any damage, I don't see how you will rationalize keeping the deposit, unless you are claiming undiscovered damage.