Approved Tuesday by Germany's Cabinet, the draft law will provide dual citizenship to those, who by the age of 21, have lived in Germany for at least eight years or have at least six years of schooling in the country.
Up until now, German-born children of immigrants have had to pick one nationality by the age of 23. German citizens are not permitted to hold two passports.
The government's approval of dual citizenship is also major victory for the center-left Social Democrat Party (SPD), the junior coalition partner of Chancellor Angela Merkel's Christian Democrats (CDU).
Changing the policy was a major sticking point for the SPD during coalition talks following September 2013 elections.
The SPD has long called for moves to liberalize Germany's strict citizenship laws but have always been met by resistance from Merkel's CDU party and their Bavarian-based sister party, the Christian Social Union (CSU).
Details of the draft law were orchestrated by Justice Minister and SPD politician Heiko Maas and Interior Minister Thomas de Maiziere of the CDU.
In a statement announcing the deal, Maas called the plan "a very significant step toward a modern citizenship policy."
The draft law is set to be approved by parliament in the coming months.
Benefits for the Turkish community
The changes will mostly benefit the more than 3 million people of Turkish origin living in Germany, a community that represents more than 4 percent of the total population.
Germany's federal commissioner for migration, refugees and integration, Aydan Özoguz, praised the draft law saying many young people can now "breathe a sigh of relief."
"I'm pleased that in future many young people will no longer have to decide against their parents' nationality or even become foreigners in their own country," she added.
However, Turkish community leaders have criticized the new law because it only applies to youngsters and does not cover those born abroad even if they have spent decades living in Germany.
hc/kms (Reuters, AFP, AP, dpa)