I'm not interested in actually playing but I'd like to weigh in here.
The title is DnD 3.5 in a Elder scrolls setting. Cross breed game like this will be full of questions like this.

To me this says mechanically - everything is DnD
Flavourwise - everything is Elder scroll

Question One:
How will magic work?
Thats a mechanical question. So you'll have clerics and they will have filled spellslots per day just like in DnD.
However the list of spells availible may be modified. Detect Evil may not make sense as alignments tend to be a flavou thing (altho it is easily ported over to a setting)
However the gods a cleric prays to would be a flavour issue and thus the Devines and each devine would need its own domains (the existing domains could be used or adapted for the setting)

Question two:
Racial Modifiers.
Again mechanical - so follow DnD logic however some races may not exist (see dwarf) and some races do not exist in Dnd see Redguard - the redguard will need DnD stat block created for them so that they can be played in a DnD mechanic set
Suggested Redguard:
+2 Con
-2 Int Or -2 Wis

+2 Fort vs Poision and Disease
All redguard are profiecient with Scimitars. If first class is alreadly proficient with scimitars then this become Weapon focus (Scimitar)
Skills
+2 Healing
+2 Knowledge (Royalty and Nobility)

Favoured Class: Fighter