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Sorry I'm responding to such an old question, but it seemed like there wasn't an answer.
So when you make an http request (which you do every time you download a podcast episode), the request includes your IP address as part of the headers; it's called "remote address," and it's a part of every http request that's made on the internet. In fact, it has to be, as this is how responses are directed back to your device.
Now, this isn't perfect, but there are code libraries that can take that IP and fetch your location from a GeoIP database. It won't get your pin-drop location unless you're connected to Wi-Fi at a place with a known IP, but it can pretty generally figure out what cell tower or broadband ISP you're connected to; that'll usually get within 50 miles or so. Easy enough to get your state if you're in the US, and probably even your city.
So when you request an episode from a podcast using dynamic ad insertion, the server does that lookup, figures out where you're from, and then chooses ads to insert: local ones if there are any, general ones if not. Then it loads up the local ads into the audio file, hopefully into preselected gaps in the audio. (And honestly, most servers actually pre-cache a bunch of these for big cities where there are a lot of subscribers.) Then they send the podcast, with ads inserted, to your phone.
Sometimes this gets weird; if you download a podcast while on vacation, for instance, or over a VPN (I'm almost always connected to a VPN, so I rarely get any local ads), or if you subscribe through a service that precaches your podcasts before your phone downloads them, so it's their IP address that starts this process rather than yours. And if it's really bizarre, you might not get any ads at all; this has happened to me on a few podcasts. They just throw to sponsors and immediately come back. That's kinda nice.