"Jerusalem is not a place, Jerusalem is an idea. Jerusalem is the capital of the Israeli state," Lapid said in an interview with The New York Times.
An interim Palestinian state should be created in the West Bank, with final borders drawn up in three to five years, Lapid said.
The area of East Jerusalem captured by Israel in the 1967 Six Day War must stay Israeli, he said.
"Israelis want peace and security and Palestinians want peace and justice -- these are two very different things and this is the real gap we have to close."
Lapid said a two-state solution is crucial for Israel's future existence but questioned the likelihood of reaching a peace deal with Palestinian President Mahmoud Abbas, saying, "He's one of the founding fathers of the victimizing concept of the Palestinians."
Lapid, whose There is a Future Party became the second largest party in Israel's national elections, was appointed finance minister in March.