The present invention provides a magnesium-modified ultra-stable rare earth type Y molecular sieve and the preparation method thereof, which method is carried out by subjecting a NaY molecular sieve as the raw material to a rare earth exchange and a dispersing pre-exchange, then to an ultra-stabilization calcination treatment, and finally to a magnesium modification. The molecular sieve comprises 0.2 to 5% by weight of magnesium oxide, 1 to 20% by weight of rare earth oxide, and not more than 1.2% by weight of sodium oxide, and has a crystallinity of 46 to 63%, and a lattice parameter of 2.454 nm to 2.471 nm. In contrast to the prior art, in the molecular sieve prepared by this method, rare earth ions are located in sodalite cages, which is demonstrated by the fact that no rare earth ion is lost during the reverse exchange process. Moreover, the molecular sieve prepared by such a method has a molecular particle size D(v,0.5) of not more than 3.0 μm and a D(v,0.9) of not more than 20 μm. Such a molecular sieve has both high stability and high selectivity for the target product, while cracking catalysts using the molecular sieve as an active component is characterized by a high heavy-oil-conversion capacity and a high yield of valuable target products.