The Primera Division giants have confirmed the capture of the attacking midfielder on a contract until the summer of 2018
The 21-year-old had also caught the attention of Manchester City as former Malaga boss Manuel Pellegrini was keen to lure him to the Premier League, but he has opted to continue his career in La Liga instead.
Madrid president Florentino Perez had already revealed on Wednesday that they were on the verge of signing the gifted youngster and they have now made the deal official.
"Real Madrid and Malaga have reached an agreement over the transfer of Francisco Roman Alarcon Isco, who will sign a five-year contract with the club," a Madrid statement reads.
"The player will undergo his medical on July 3 and then be presented to the press at the Santiago Bernabeu."
Isco is a product of the Valencia youth academy, but left los Che in the summer of 2011 in an attempt to get regular playing time elsewhere.
He had since developed into a key player at Malaga and was one of the stars of the Spain U-21 team that were crowned European champions in Israel this summer.