#2 is good. #1 sounds good, whether or not it makes sense. I would change it to: "The town is like a place in a fairy tale." "The town is like something from (or 'out of') a fairy tale" "The town is like in (or 'from') a fairy tale" My last sentence might not be grammatical, but it sounds good and it is something people would say.

This town is like living in a fairy tale.

The first is natural but vague by itself. You can say: The town looks like it is out of a fairy tale. Living in this town feels like living in a fairy tale. My neighbors in this town resemble characters from a fairy tale. Etc.

Both sentences are correct and natural. Here's a slight variation for each: 1. "The town feels like something out of a fairy tale." 2. "The town has a magical, fairy-tale-like atmosphere." These emphasize the magical quality of the town even more, but your original sentences are perfectly fine.

Both are correct with subtle differences. "The town is like a fairy tale." The tone of this sentence shares an idea that the speaker felt they stepped into a different world (a fairy tale). They were immersed in and surrounded by the fairy tale. It seems likely to the listener that the speaker felt a high emotional response (good or bad) to the town. "The town has a fairy tale atmosphere." The tone of this sentence shares that of a more serious observation. The speaker saw things in the town that, together, reminded them of towns or things in fairy tales. The speaker doesn't sound as though they felt they stepped into a different world. It is a more detached opinion than the first sentence. Both sentences could be good or bad depending on if the speaker likes or dislikes fairy tales. 🧚‍♀️📜✨