With the advent of 4.2(1)SV1(5.1), Cisco now recommends that you configure your SVS domain mode as Layer 3 for VSM-to-VEM communication. Note: The installation still defaults to Layer 2. This recommendation comes to support best practices for VXLANs:
http://www.cisco.com/en/US/docs/switches/datacenter/nexus1000/sw/4_2_1_s_v_1_5_1/install_upgrade/vsm_vem/guide/n1000v_installupgrade_overview.html#wp1083068
I had a heck of a time going from L2 to L3 in one instance. The documentation makes it seem easy, though compared to running through configuration for VXLAN, it's a breeze! :-)
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