Madrid confirmed the news via a short statement on their website and Twitter account.
Modric, 28, signed for Madrid from Tottenham in 2012 and last season played a key role in their successful Champions League and Copa del Rey campaigns.
The Croatia midfielder also started in the UEFA Super Cup win over Sevilla and played in Tuesday night's 1-1 draw with Atletico Madrid, the first leg of the Spanish Super Cup.
Madrid signed Germany star Toni Kroos to strengthen their options in midfield but Modric looks certain to retain a key role in Carlo Ancelotti's side, with Angel Di Maria the player to make way for the former Bayern pass master.
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