The agreement was signed by US Ambassador Mike Huckabee and Israeli Foreign Minister Gideon Sa'ar on Wednesday.
The building will replace the current embassy, which was moved from Tel Aviv after President Donald Trump recognized Jerusalem as the capital of Israel in 2017.
The status of Jerusalem is one of the most contentious core issues in the Israel-Palestine conflict, as both Israeli and Palestinian representatives want to see it as their capital in a future two-state solution.
The agreement comes amid a period of tensions between the US and Israel as a result of the ongoing war with Iran.
