LMFAO stands for Laughing My Fucking Ass Off. It is internet slang, generally used by Youngsters over internet chatting, messaging, chit chat conversation etc. This term is used to represent something really -really funny (extremely funny). There are also some substitutes used for the funny condition like LOL, LMAO etc. But this is used for an extremely funny condition.
Let's take an example: Two friends are chatting on facebook: