Lung alveolar development in late gestation is a process important to postnatal survival. Follistatin-like 1 (Fstl1) is a matricellular protein of the Bmp antagonist class, which is involved in the differentiation/maturation of alveolar epithelial cells during saccular stage of lung development. This study investigates the role of Fstl1 on elastin deposition in mesenchyme and subsequent secondary septation in the late gestation stage of terminal saccular formation. To this aim, we modified the renal capsule allograft model for lung organ culture by grafting diced E15.5 distal lung underneath the renal capsule of syngeneic host and cultured up to 7 days. The saccular development of the diced lung allografts, as indicated by the morphology, epithelial and vascular developments, occurred in a manner similar to that in utero. Fstl1 deficiency caused atelectatic phenotype companied by impaired epithelial differentiation in D3 Fstl1(-/-) lung allografts, which is similar to that of E18.5 Fstl1(-/-) lungs, supporting the role of Fstl1 during saccular stage. Inhibition of Bmp signaling by intraperitoneal injection of dorsomorphin in the host mice rescued the pulmonary atelectasis of D3 Fstl1(-/-) allografts. Furthermore, a marked reduction in elastin expression and deposition was observed in walls of air sacs of E18.5 Fstl1(-/-) lungs and at the tips of the developing alveolar septae of D7 Fstl1(-/-) allografts. Thus, in addition to its role on alveolar epithelium, Fstl1 is crucial for elastin expression and deposition in mesenchyme during lung alveologenesis. Our data demonstrates that the modified renal capsule allograft model for lung organ culture is a robust and efficient technique to increase our understanding of saccular stage of lung development.