"They are washing the potatoes."
Translation:Sie waschen die Kartoffeln.
You can tell the difference between "she" and "they"/"you" by the verb form, which ends in -t for "she" and in -en for "they"/"you".
For example, sie wäscht with -t for "she is washing", sie waschen with -en for "they are washing", and *Sie waschen" with -en and always with capital S for "you are washing".
In the middle of a sentence, you can tell the difference between "they" and "you" because "they" has lowercase sie but "you" has capitalised Sie. At the beginning of sentence, when sie/Sie is the first word of the sentence and is therefore always capitalised, only context lets you know whether the word means "they" or "you".
What kind of exercise or question did you have exactly?
The system generates various types of exercises for the same sentence and they all share the same sentence discussion, so it's not possible to guess what you might have had.
Two I can think of are:
(a) You have a sentence with a gap and you have to fill in the gap with one out of a handful of words. Of those, only one is grammatically correct.
Did you have this kind of exercise? If so, what were your choices to fill the gap? You shouldn't have both waschen and wäscht - that would be bad exercise design.
But if you had, say, waschen and wascht, then only waschen can be correct since sie wascht is not correct German. (The verb form wascht is for ihr wascht.)
(b) You have an English sentence and have to translate it into German.
Did you have this kind of exercise? Then your context is the English sentence.
It would be really helpful if we could see exactly what you saw -- in the future, it would be great if you could make a screenshot showing the question (and all of its options) as well as your answer, upload it to a website somewhere such as imgur or postimage, and include the URL of the image in your comment here.
I can't think of an exercise that gives you Sie ... die Kartoffeln and makes you fill in the blank without any context at all (neither an English sentence nor a limited number of choices to choose from, only one of which is correct).
It's a possible translation, if you want to emphasise either the subject, the object, or the verb -- in English, you might use a cleft for this: "It's the potatoes that they are washing" or "It's they who are washing the potatoes" or "What they do to the potatoes is washing them".
why is there no difference between "they wash" and "they are washing" for example.
Because German doesn't distinguish that grammatically.
Much as English doesn't distinguish "Tom did it (and I know that for a fact)" from "Tom did it (or so I heard)" grammatically, even though some languages go.
is there a way to differenciate these tenses?
No. And no need to, either.
If a typo results in a real German word (but the wrong one for this context), you'll get marked as a full error, because Duolingo can't tell whether you put the wrong word on purpose or because you left out a letter accidentally.
wachen is "to wake" or "to watch, guard".
Why couldn't I write 'Sie sind waschen die Kartoffeln'?
Because sind doesn't belong in that sentence in German. German doesn't need a helping verb in the present tense -- sie waschen is enough to translate "they are washing".
Adding an extra verb that doesn't belong there would be like saying "They do are washing the potatoes" in English. It simply makes no sense.