An individual's Magical Realm is the domain of their sexual fetishes, especially in relation to roleplaying games. When a game starts developing or introducing elements of the player or GM's fetishes, either accidentally or deliberately, it is said to be entering their magical realm.
The origin of the phrase is the skit "Piss World" from KC Green's webcomic Gunshow, where the players of a tabletop RPG react violently to their GM repeatedly trying to get them to play to his urine fetish. A panel has an NPC (presumably a DMPC) called the "Whizzard" asks "Dare you enter my magical realm?" The skit ends with the players punching him out. Amusingly, the "Whizzard" looks a bit like Ed Greenwood, who is notorious for doing this in his writings, and his Magical Realm self-insert Elminster.
When the phrase "Magical Realm" is used to describe a work (usually a setting or adventure module), the implication is that the author either let their fetishes bleed into the work sufficiently to make it very obvious what gets them off, or even created the work entirely for the sole purpose of sexual gratification without explicitly saying so. Bonus points if they insist otherwise despite overwhelming evidence to the contrary.
Similarly, it is possible for a player or DM to try and force their magical realm onto a setting by acting upon their fetishes, or having particular reactions to something as mundane as, say, lizardfolk. A more basic version is simply hitting on every tavern wench from Mendev to Absalom in an attempt to get laid in a way that the player cannot in real life. This is considered bad form because it puts the gratification of their fetish before the fun of the rest of the group. A DM who habitually forces his Magical Realm upon the players is called a /d/M.
Drawing the Line
One of the problems with defining "magical realm" is that, sometimes, legitimate aspects of the setting can sound really, really fucked up when discussed casually. Due to many cases of such, a lot of threads about magical realms on /tg/ are anons trying to find the precise line when something goes from "fantastical" to "perverse". As with debates regarding furries, beastfolk and monstergirls, the primary keys are context, context, context, and the sanity with which the concept is approached. Intent also goes a long way, naturally: the DM might describe a sewer's horrible smell in-depth not because he's a fart fetishist, but because he wants to improve the group's immersion and not have the characters jump in the sludge without a care.
For example, in Empire of the Petal Throne, one of the potential PC races are the Mihalli: shapeshifting alien wizards whose "default" form is a humanoid lion with 4-6 breasts and who are reputed to be hermaphroditic. And, to be honest, "multi-tittied herm lioness wizard" sounds like something straight out of a stereotypical furry's magical realm... but here they are treated as just an ordinary, mundane aspect of life on Tekumel.
A quick comparison to the other races of the setting makes it clear that the hermaphrodite thing is just a case of contextually appropriate weirdness (assuming it's even true, given the Mihalli's reproductive practices aren't exactly documented): all the non-human PC races are similarly strange in one way or another, with one species faces four directions at once and has eight biological sexes (and funnily enough, their reproduction methods aren't well know to outsiders, either), and another whose members resemble glass sculptures and are a eusocial hivemind. The Mihalli are almost certainly intended to be aliens that actually feel alien, and are neither aliens whose only difference from a stock human is that they have funny ridges on their foreheads, nor aliens whose shtick is summarized by the phrase "they're like that because It Gets Me Off™" -- in particular, they lack the usual Mary Sue bullshit that is a distinguishing feature of the latter (e.g., the main reason they're a minor race? They lost a large scale war against the Humans when their capital city got nuked, resulting in them having to flee into the shadows).
- Forgotten Realms, the original Magical Realm of Ed Greenwood.
- Monster Girl Encyclopedia, for an example of a setting that qualifies and isn't mindbogglingly awful, but still plenty skubby beyond that.
- FATAL, for an example of a game system that qualifies, and is mindbogglingly awful.
- Book of Erotic Fantasy, for an example of a work that doesn't probably quite qualify as a "magical realm", for reasons of being too openly and explicitly about sex.
- Maid RPG, for an example of a self-aware Magical Realm.
- Wraeththu RPG, for an example of a work that qualifies as a Magical Realm twice over, being one reader's Magical Realm RPG version of an already existing Magical Realm series of novels, and an excellent example of what happens when you go two Magical Realms deep (i.e., sheer horror).
- Magical Realm CYOA, a popular CYOA that can be overlapped with the /tg/ meaning of "Magical Realm", but also can just be taken in a non-sexualised direction.
- FAPP, a furry tabletop game about what happens when the magical realm enters you.
- CthulhuTech, for its copious uses of raep and romance railroading in its adventures (read: getting raped by furries), along with the uber hedonistic society of the NEG.
- Anything by Chris A. Field, particularly Black Tokyo.