Transforming growth factors beta (TGF-beta) are known negative regulators of lung development, and excessive TGF-beta production has been noted in pulmonary hypoplasia associated with lung fibrosis. Inhibitory Smad7 was recently identified to antagonize TGF-beta family signaling by interfering with the activation of TGF-beta signal-transducing Smad complexes. To investigate whether Smad7 can regulate TGF-beta-induced inhibition of lung morphogenesis, ectopic overexpression of Smad7 was introduced into embryonic mouse lungs in culture using a recombinant adenovirus containing Smad7 cDNA. Although exogenous TGF-beta efficiently reduced epithelial lung branching morphogenesis in control virus-infected lung culture, TGF-beta-induced branching inhibition was abolished after epithelial transfer of the Smad7 gene into lungs in culture. Smad7 also prevented TGF-beta-mediated down-regulation of surfactant protein C gene expression, a marker of bronchial epithelial differentiation, in cultured embryonic lungs. Moreover, we found that Smad7 transgene expression blocked Smad2 phosphorylation induced by exogenous TGF-beta ligand in lung culture, indicating that Smad7 exerts its inhibitory effect on both lung growth and epithelial cell differentiation through modulation of TGF-beta pathway-restricted Smad activity. However, the above anti-TGF-beta signal transduction effects were not observed in cultured embryonic lungs with Smad6 adenoviral gene transfer, suggesting that Smad7 and Smad6 differentially regulate TGF-beta signaling in developing lungs. Our data therefore provide direct evidence that Smad7, but not Smad6, prevents TGF-beta-mediated inhibition of both lung branching morphogenesis and cytodifferentiation, establishing the mechanistic basis for Smad7 as a novel target to ameliorate aberrant TGF-beta signaling during lung development, injury, and repair.