This study deals with an on-line software fault detection, localization, and system reconfiguration method for electrical system drives composed of three-phase AC/DC/AC converters and three-phase permanent magnet synchronous machine (PMSM) drives. Current sensor failure (outage), speed/position sensor loss (disconnection), and damaged DC-link voltage sensor are considered faults. The occurrence of these faults in PMSM drive systems degrades system performance and affects the safety, maintenance, and service continuity of the electrical system drives. The proposed method is based on the monitoring signals of "abc" currents, DC-link voltage, and rotor speed/position using a measurement chain. The listed signals are analyzed and evaluated with the generated residuals and threshold values obtained from a Sliding Mode Current-Speed-DC-link Voltage Observer (SMCSVO) to acquire an on-line fault decision. The novelty of the method is the faults diagnosis algorithm that combines the use of SMCSVO and adaptive thresholds; thus, the number of false alarms is reduced, and the reliability and robustness of the fault detection system are guaranteed. Furthermore, the proposed algorithm's performance is experimentally analyzed and tested in real time using a dSPACE DS 1104 digital signal processor board.