The sense of smell may still be operational during sleep, but it is not enhanced. Olfactory stimuli typically will not wake you up during sleep, however.
Olfaction and sleep are an interesting lot. Most sensory stimuli presented during sleep typically cause awakening, especially when when they are intense and sudden (e.g. a loud noise). This is not the case with odors, and even holds for unpleasant ones (Carskadon & Herz, 2004).
In addition, while most sensory systems stop processing their input altogether, odors remain processed by the sleeping brain. This may, at least in part, be due to the direct olfactory projections from the periphery to the cortex, without a thalamic relay being used as with the other senses (Perl et al., 2017). However, they will typically not wake a person up.
The neural adaptation (reduction of sensitivity over time) of the olfactory system is related to repeated or sustained exposure to scents (Dalton, 2000), and it is not affected by sleep per se as far as I know. Hence, taken together these findings support the claim that odor alarms will not work.
Note, however, that fire comes with heat and irritant smoke that will work on the heat and pain receptors in the skin, respectively. These may wake you up, barred the dulled sensory systems pick the stimuli up. And even then it may already be too late to be of any help.
- Dalton, Chem Senses (2000); 25(4): 487-92
- Carskadon & Herz, Sleep (2004); 27(3): 402-5
- Perl et al, Springer Handbook of Odor: 111-2