"My dad passed away just before Christimas and left his estate to me, my brother and my sister. His will states that any money owed by us is to be taken off our share of the estate. My question is….where does this money go? Does it get put back into the estate and then split 3 ways?"
You have pretty much summarized exactly what happens.
When parents lend or give money to their adult children, it is considered by law to be an advance on the children's inheritance. For this reason, the loans or gifts have to be taken off the children's inheritance, which is often referred to as being "set off" against the inheritance. As I mentioned above, a parent who doesn't want the loans or gifts to be set off can specifically say so in his or her will. Parents should understand that the executor doesn't have the legal authority to forgive the loans unless the will says so.
As always, the beneficiaries don't inherit their shares until all taxes, debts and liabilities of the estate have been paid. Once that has been done, the executor will calculate each beneficiary's share of what is left.
When the executor sends you his accounting of the estate, it should include a statement showing what he proposes to give each beneficiary. You should be able to see from this accounting how your loan affects the amount you and others will receive. Occasionally the math gets a bit complicated when there are loans to several beneficiaries to take into consideration, but this is an important part of the executor's accounting.