To examine the consequences of repressing beta-catenin/Lef1 signalling in mouse epidermis, we expressed a DeltaNLef1 transgene, which lacks the beta-catenin binding site, under the control of the keratin 14 promoter. No skin abnormalities were detected before the first postnatal hair cycle. However, from 6 weeks of age, mice underwent progressive hair loss which correlated with the development of dermal cysts. The cysts were derived from the base of the hair follicles and expressed morphological and molecular markers of interfollicular epidermis. Adult mice developed spontaneous skin tumours, most of which exhibited sebaceous differentiation, which could be indicative of an origin in the upper part of the hair follicle. The transgene continued to be expressed in the tumours and beta-catenin signalling was still inhibited, as evidenced by absence of cyclin D1 expression. However, patched mRNA expression was upregulated, suggesting that the sonic hedgehog pathway might play a role in tumour formation. Based on our results and previous data on the consequences of activating beta-catenin/Lef1 signalling in postnatal keratinocytes, we conclude that the level of beta-catenin signalling determines whether keratinocytes differentiate into hair or interfollicular epidermis, and that perturbation of the pathway by overexpression of DeltaNLef1 can lead to skin tumour formation.