Well, are we only supposed to live our faith and values when it's convenient to us?
'Sis, we love you. But I truly believe what you are doing is morally wrong and I do not want my children to think I approve. Since I am trying to raise them in the Catholic faith it would send conflicting messages to them and make me appear to be a hypocrite. We love seeing you and the kids, but I just can't bring my kids here."
No, I would not want my kids over there. It is a horrible example and by being 'politically correct' and non-judgemental and 'looking the other way' you are tacitly approving and sending your children the message this is an option for them in the future. The SIL is being used, and she's using her boyfriend in their arrangement without committment, but that's actually not a religious issue but something for your kids to learn eventually on a practical level. I pray they stay together because of the bonds their children are developing. If the relationship ends that could be devastating to the little ones. But in our society, with disposable relationships, families form and disperse with step-brothers/sisters constantly changing and eroding a sense of stability in the young.
I'll assume you used language here out of frustration that you would never use with your wife or SIL. Kind of venting here, ok. But bottom line, she is not treating herself with respect and not acting in a way worthy of respect. There's never an excuse to be rude, but one can certainly draw lines based on one's faith politely. Either your wife is onboard with raising the kid's Catholic or she's not, she needs to decide because her loving acceptance of her sister's relationship is sending the message to the kids it's ok. Does she want her daughter/son shacking up with someone down the road? Does she want them to think of relationships as disposable? Scandal is misleading others into sin- and not clearly delineating what is moral/immoral to kids in their formative years, IMHO, qualifies.
As to tolerance, Jesus said when we have a problem with our brother, try to correct them in private, if they don't listen, approach them with witnesses, if they still refuse to listen, go to the Church. If they refuse to listen- even to the Church- treat them as (an ancient Jew would have) tax collectors or gentiles.
Now, I wouldn't cut off all relations with the sister. Set a good example, as you said love the sinner but not the sin. Which means, you have to demonstrate that you believe what she's doing is wrong through your actions. And I think not going there, but visiting with her other places is a good method.
ETA: Christ wasn't very popular either, particularly to the Pharisees, a lot of folks didn't want to hear His words on how to live.