This is a Family Code Section 2640 issue, not a transmutation or commingling issue. The houses were both community property. However, if your wife can trace the funds from her inheritance to the down payment on the 1st home (whose net sales proceeds went into the existing home), she will be able to recover those separate property funds, dollar for dollar (without interest or appreciation) before the community property balance is divided 50/50.
Please note that this answer does not constitute legal advice, and should not be relied on, as each situation is fact specific, and it is not possible to evaluate a legal problem without a comprehensive consultation and review of all the facts and court pleadings filed in the case. This answer does not create an attorney-client relationship.
The question is not of transmutation or commingling, but of tracing. If the inheritance money can be traced back to the inheritance, than that part will remain separate property. Any portion of it that has grown in the form of a capital gain, would be community property.
Attorney Williams practices FAMILY LAW throughout the State of California. The response provided in this forum is not intended to create an attorney-client relationship. The information offered in this response is for general informational purposes only and should not be relied upon without further consultation with a legal professional after all relevant facts are disclosed and considered. DANIEL S. WILLIAMS, ESQ. LAW OFFICES OF DANIEL S. WILLIAMS 500 LIGHTHOUSE AVENUE, STE. A MONTEREY, CA 93940 (831) 233-3558 -- OFFICE (831) 233-3560 -- FAX
The short answer is that unless the some or all of the transactions occurred before approximately 1984, she can at least make a plausible claim, although she'll need to present evidence as to the source of the original money, and the tracing of the money through the various later transactions. Whether or not she has a good claim, with a high chance of success, depends on a bunch of facts, which you should review with an experienced family law attorney. Tracing/transmutation law is definitely NOT a "do it yourself" project, and to be able to mediate this issue usefully, you need legal advice as to what your best/worst case is if you go to court.