Modric remains a key player for Madrid and decided to stay despite strong interest from Saudi Arabia, looking to recruit him at the end of his previous contract, which expires this month.
The Croatian follows Toni Kroos, Dani Ceballos and Nacho Fernandez in extending his time at Madrid this summer.
"In his 11 seasons defending our shirt, he has played 488 games and won 23 trophies," said Real Madrid in a statement.
Modric has lifted the Champions League five times with Madrid since joining in 2012 from Tottenham, as well as La Liga on three occasions and two Copas del Rey.
Turning 38 in September, 2018 Ballon d'Or winner Modric faces stiff competition next season at the Santiago Bernabeu.
Madrid signed England international Jude Bellingham from Borussia Dortmund for over £85 million earlier in June, while Kroos, Ceballos, Eduardo Camavinga, Aurelien Tchouameni and Fede Valverde are jostling for places.
Youngster Bellingham said at his presentation he was looking forward to learning from Modric and Kroos in particular.
Modric finished second with Croatia in the Nations League and has not yet announced whether he will retire from international football, as was rumoured, or if he will continue until the 2024 European Championship next summer.
