The 28-year-old, who played on loan for the Spanish club in 2011-12, needs to agree personal terms with the Madrid outfit to complete the transfer.
"Yesterday we received the offer from Madrid," Alloff told Kicker.
"We had to weigh out the pros and cons. We found a loan agreement - I see it as degrading for us if we sell Diego."
Diego's contract with Wolfsburg runs out at the end of the season.