Follistatin-like 1 (FSTL1) is a secreted bone morphogenetic protein (BMP) antagonist, and it plays a crucial role in normal lung development. Deletion of Fstl1 leads to postnatal death in mice due to respiratory failure. To further explore the role of FSTL1 in mouse lung development, we created a transgene SFTPC-Fstl1 allele mouse displaying significant epithelial overexpression of Fstl1 in all stages of lung development. However, epithelial overexpression of Fstl1 did not alter lung morphogenesis, epithelial differentiation and lung function. Moreover, we found that FSTL1 function was blocked by the epithelial polarization, which was reflected by the remarkable apical secretion of FSTL1 and the basolateral BMP signaling. Taken together, this study demonstrates that tightly spatial interaction of FSTL1 and BMP signaling plays an essential role in lung development.