Since your wife and her sister each owned 50% of the home, when it was sold your wife would report her share as Sale of Inherited Property in the Investment section and enter the 1099-S.
She would need to determine what her Cost Basis in the property was, in order to report either a Gain or Loss.
Click this link for info on Calculating Basis of Gift Property.
As @Carl says above, you should not have to pay tax on Rental Income you never received, and you have your prior year tax returns to prove that.
The IRS would probably not object if you claimed the income her sister sent as 'Other Income' in your return, and pay the tax on it without setting up the Rental Property in your return.
However, his advice to seek legal advice is definitely sound.
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