This study identifies two distinct fibroblast lineages in skin development and repair. One lineage forms the upper dermis, including the dermal papilla and arrector pili muscle, and is essential for hair follicle formation. The other forms the lower dermis, including reticular fibroblasts and hypodermal pre-adipocytes and adipocytes. In wounded skin, the lower lineage initiates repair, while upper dermal fibroblasts are recruited during re-epithelialization. Epidermal β-catenin activation promotes upper dermal lineage expansion, enabling hair follicle formation. These findings explain why wounds lead to ECM-rich scar tissue lacking hair follicles. The study also provides a framework for understanding fibroblast lineages in other tissues and for examining fibroblast changes in aging and disease. During development, fibroblasts in the upper and lower dermis express different markers. At E12.5, markers like CD26 and Blimp1 are expressed in the upper dermis, while Sca1 is expressed in the lower dermis. By E18.5, Dlk1 is expressed in the lower dermis, and Lrig1 in the upper dermis. Lineage tracing using CreER mice confirmed that Dlk1+ cells give rise to lower dermal lineages, while Blimp1+ cells give rise to upper dermal lineages, including the dermal papilla and arrector pili muscle. These findings show that by E16.5, dermal fate is restricted, with Dlk1+ cells forming the lower dermis and Blimp1+ cells forming the upper dermis. In adult skin, the first wave of dermal regeneration depends on the lower dermis, which does not support hair follicle formation. The upper dermal lineage is not repopulated until re-epithelialization and contributes exclusively to the papillary dermis. Epidermal β-catenin activation expands both upper and lower dermal compartments, making the upper dermis permissive for new hair follicle formation. This study reveals the cellular origins of the heterogeneous dermis and provides a mechanistic basis for understanding skin repair and epidermal Wnt activation. It also offers opportunities to study dermal lineage specification and its role in aging and tumour formation.This study identifies two distinct fibroblast lineages in skin development and repair. One lineage forms the upper dermis, including the dermal papilla and arrector pili muscle, and is essential for hair follicle formation. The other forms the lower dermis, including reticular fibroblasts and hypodermal pre-adipocytes and adipocytes. In wounded skin, the lower lineage initiates repair, while upper dermal fibroblasts are recruited during re-epithelialization. Epidermal β-catenin activation promotes upper dermal lineage expansion, enabling hair follicle formation. These findings explain why wounds lead to ECM-rich scar tissue lacking hair follicles. The study also provides a framework for understanding fibroblast lineages in other tissues and for examining fibroblast changes in aging and disease. During development, fibroblasts in the upper and lower dermis express different markers. At E12.5, markers like CD26 and Blimp1 are expressed in the upper dermis, while Sca1 is expressed in the lower dermis. By E18.5, Dlk1 is expressed in the lower dermis, and Lrig1 in the upper dermis. Lineage tracing using CreER mice confirmed that Dlk1+ cells give rise to lower dermal lineages, while Blimp1+ cells give rise to upper dermal lineages, including the dermal papilla and arrector pili muscle. These findings show that by E16.5, dermal fate is restricted, with Dlk1+ cells forming the lower dermis and Blimp1+ cells forming the upper dermis. In adult skin, the first wave of dermal regeneration depends on the lower dermis, which does not support hair follicle formation. The upper dermal lineage is not repopulated until re-epithelialization and contributes exclusively to the papillary dermis. Epidermal β-catenin activation expands both upper and lower dermal compartments, making the upper dermis permissive for new hair follicle formation. This study reveals the cellular origins of the heterogeneous dermis and provides a mechanistic basis for understanding skin repair and epidermal Wnt activation. It also offers opportunities to study dermal lineage specification and its role in aging and tumour formation.