Hart has been seeking first-team football since being squeezed out at Eastlands by the arrival of Shay Given in January.
City snapped up Stuart Taylor from Aston Villa on Tuesday, providing the cover they needed to let Hart go.
The 22-year-old, who is on international duty with the Under-21s at the European Championships, has one senior cap and wants to be playing regularly in the build-up to the World Cup, having lost his place in Fabio Capello's squad since dropping down the City pecking order.
Hart has made 33 starts for City and showed great potential, something boss Mark Hughes now hopes he can build on with another season's experience.
"I have always said that Joe is a really good young keeper, and his talent was obvious to (goalkeeping coach) Kevin Hitchcock and I from the outset," Hughes told City's official website.
"His contribution to the team prior to Shay Given's arrival was fantastic, but by loaning him to Birmingham, he will add invaluable experience to that already gained here at City.
"I know he will relish the prospect of regular Premier League action, which is vital at this stage in his career."
Hart, who joined City from Shrewsbury in 2006, has admitted that it has been frustrating to sit on the sidelines after a taste of being the number one.
"It has been tough. It's frustrating, but there's only one person can play in goal and Shay's doing that at the moment," he said.
"I've had to deal with it the best I can. It's not been ideal, but it's not the end of the world."