Hi J.,
With your toddler, I'd approach talking to him about the loss as no one being able to see or spend time with this relative again, that she has passed away and is gone to heaven -and that only other people in heaven can see and spend time with her now. I wouldn't say her soul is gone, just 'her', as I don't think your son can grasp our soul leaving our body (if you believe in God, that is -if you don't, I doubt you'll say she's gone to heaven, although, I think at his age he needs a 'place' that she's moved on to, whatever your beliefs are). I doubt he'll grasp it at all, but it will make enough sense to him that he won't see her again if you tell him that, in particular. It might help him understand (a little) about why other relatives he will see seem sad or 'miss' her... because they won't get to see her again either, as they are not in heaven. I wouldn't say much and I'd keep it pretty simple. I think your desire to answer his 'why' is right-on, and I do not think it's inappropriate to tell him a 'version' of death tailored to his age at all. Death is part of life and reaches everyone of all ages at some time or another. Sadness and grief, too, are part of life and he will likely see a bit of sadness and grief when he visits other relatives. I really believe that, if approached gently for young children's awareness, death & grief can be learned to be (although very painful, also) just that, another part of life --some things are joyous, happy and sometimes there are births and new babies.. other times things can be sad and sometimes there are deaths in the family and in the world. (For every season... )
My condolences to your brother and sister-in-law's family and all who knew and loved your brother's mother-in-law. I hope she didn't suffer and was able to live as full a life as possible before her passing.
I talked with my son 'young' about the death of a loved one, too (we lost his brother when my living son was a yr older than your son is now --and my son had begun to have rudimentary understandings of the concept all on his own months before our loss). I also grew up knowing about death from a young age, so young I don't even remember the age (but it was pretty young)... just always knew I had a sister that died before I was born (and I'm glad I did know that growing up, glad my mother shared that with me in the 'part of our life, part of our history' way she did.. not at all upsetting to me, but a gift).