This paper proposes a condition-based maintenance (CBM) policy for a deteriorating system whose state is monitored by a degraded sensor. In the literature of CBM, it is commonly assumed that inspection of system state is perfect or subject to measurement error. The health condition of the sensor, which is dedicated to inspect the system state, is completely ignored during system operation. However, due to the varying operation environment and aging effect, the sensor itself will suffer a degradation process and its performance deteriorates with time. In the presence of sensor degradation, the Kalman filter is employed in this paper to progressively estimate the system and the sensor state. Since the estimation of system state is subject to uncertainty, maintenance solely based on the estimated state will lead to a suboptimal solution. Instead, predictive reliability is used as a criterion for maintenance decision-making, which is able to incorporate the effect of estimation uncertainty. Preventive replacement is implemented when the estimated system reliability at inspection hits a specific threshold, which is obtained by minimizing the long-run maintenance cost rate. An example of wastewater treatment plant is used to illustrate the effectiveness of the proposed maintenance policy. It can be concluded through our research that: 1) disregarding the sensor degradation while it exists will significantly increase the maintenance cost and 2) the negative impact of sensor degradation can be diminished via proper inspection and filtering methods.