The most severe and fatal infections with SARS-CoV-2 result in the acute respiratory distress syndrome, a clinical phenotype of coronavirus disease 2019 (COVID-19) that is associated with virions targeting the epithelium of the distal lung, particularly the facultative progenitors of this tissue, alveolar epithelial type 2 cells (AT2s). Little is known about the initial responses of human lung alveoli to SARS-CoV-2 infection due in part to inability to access these cells from patients, particularly at early stages of disease. Here we present an in vitro human model that simulates the initial apical infection of the distal lung epithelium with SARS-CoV-2, using AT2s that have been adapted to air-liquid interface culture after their derivation from induced pluripotent stem cells (iAT2s). We find that SARS-CoV-2 induces a rapid global transcriptomic change in infected iAT2s characterized by a shift to an inflammatory phenotype predominated by the secretion of cytokines encoded by NF-kB target genes, delayed epithelial interferon responses, and rapid loss of the mature lung alveolar epithelial program. Over time, infected iAT2s exhibit cellular toxicity that can result in the death of these key alveolar facultative progenitors, as is observed in vivo in COVID-19 lung autopsies. Importantly, drug testing using iAT2s confirmed an antiviral dose-response to remdesivir and demonstrated the efficacy of TMPRSS2 protease inhibition, validating a putative mechanism used for viral entry in human alveolar cells. Our model system reveals the cell-intrinsic responses of a key lung target cell to infection, providing a physiologically relevant platform for further drug development and facilitating a deeper understanding of COVID-19 pathogenesis.