A method and apparatus are disclosed from the perspective of a first UE (User Equipment) to update Layer-2 Identities (IDs). In one embodiment, the method includes the first UE establishing a unicast link with a second UE, wherein a first Layer-2 ID of the first UE and a second Layer-2 ID of the second UE are used for data transmission and reception on the unicast link. The method further includes the first UE transmitting a Link Identifier Update Request message for the unicast link to the second UE, wherein the Link Identifier Update Request message includes a new first Layer-2 ID of the first UE. The method also includes the first UE receiving a Link Identifier Update Accept message for the unicast link from the second UE, wherein the Link Identifier Update Accept message includes a new second Layer-2 ID of the second UE. In addition, the method includes the first UE passing the new first Layer-2 ID of the first UE and the new second Layer-2 ID of the second UE down to the lower layer(s) after a Link Identifier Update Acknowledgement (ACK) message is passed to the lower layer(s) for transmission in response to reception of the Link Identifier Update Accept message.