Two buildings containing 13 apartments in all are to be built in Sheikh Jarrah, a prominent battleground between Palestinians and Jewish settlers who want to cement Israel's hold on east Jerusalem - sometimes by evicting longtime Arab residents.
In the past, the U.S. has denounced such projects as hampering peace efforts. The U.S. Embassy had no comment on the latest project.
City Hall spokesman Elie Isaacson said the municipal planning committee discussed the project on Monday. It will now seek public comment on the plan.
Isaacson said municipal officials are required to discuss all construction plans for the city but emphasized that the project was being promoted by private developers and not the municipality.
"Discriminating against those who issue zoning requests on the basis of their religion, color or creed would be both illegal and completely immoral," he said.
The Haaretz newspaper said an unspecified number of Palestinian families would have to be evicted from their homes for construction to begin. Isaacson said he did not know if that was accurate.
The plan must clear additional bureaucratic obstacles, and actual construction could be years away. But even talk of altering the situation on the ground in east Jerusalem can be explosive.
"A step of this kind will complicate issues further and negatively affect the prospect of resuming negotiations," said Palestinian spokesman Ghassan Khatib.
The latest round of peace talks broke down in September after just three weeks following the expiry of an Israeli slowdown on settlement construction in areas claimed by the Palestinians.
The Palestinians seek both the West Bank and east Jerusalem - areas captured by Israel in the 1967 Mideast war - for part of their future state. Israel has annexed east Jerusalem in a move the international community does not recognize.
Palestinians see Jewish construction in east Jerusalem as an effort to entrench Israel's presence in the disputed sector of the city. The fate of the holy city, home to sacred Jewish, Muslim and Christian shrines, is one of the most divisive issues in the Israeli-Palestinian conflict.
Some 200,000 Jews have moved to east Jerusalem since 1967. Most live in Jewish enclaves that have been built since that time and are expected to remain under Israeli sovereignty under any future peace deal.
Several thousand, however, have settled in the heart of Arab neighborhoods like Sheikh Jarrah, which the Palestinians want to control as part of a final accord.
The Palestinians, and the international community, consider all Israeli construction in east Jerusalem to be illegal settlement activity.
Dovish city councilman Meir Margalit accused officials of taking advantage of the turmoil in Egypt to put the approval process in motion.
"My sense is that they know America is busy with Egypt and doesn't have the strength or the interest in dealing with it now," he said.