Expression of the Dlx3 homeodomain gene is induced in terminally differentiated epidermal cells. Dlx3 regulates gene expression in skin and plays important roles in patterning of the embryonic ectoderm through differential sensitivity to bone morphogenetic protein (BMP) signaling. We analyzed the expression of BMP family members in murine keratinocytes; BMP-2 is expressed in proliferative basal and differentiated suprabasal keratinocytes. BMP-2 induced transcription of Dlx3 within 12 h of treatment of keratinocytes cultured in vitro. We proceeded to delineate the BMP-2-responsive region to an area between -1917 and -1747 in the Dlx3 promoter. Gel shift assays with recombinant Smad1 and Smad4 demonstrated that this DNA fragment (-1917 to -1747) was competent in the formation of protein-DNA complexes. By deletion and mutational analyses we localized a Smad1/Smad4-binding site containing a GCAT motif, which showed similarity to other TGF-beta family responsive elements. Supershift assays with keratinocyte nuclear extracts and antibodies against members of the Smad family showed that this motif was able to form a complex with Smad1. Mutation of the Smad1/Smad4-binding site inhibited transcriptional activation of the Dlx3 gene by BMP-2. In the hair follicle, where Dlx3 is expressed in the hair matrix cells, BMP-2 also activates Dlx3 transcription. These results provide a possible mechanism of action for the BMP signaling pathway on the regulation of Dlx3.