TGF-β1 has long been considered as a key mediator in diabetic kidney disease (DKD) but anti-TGF-β1 treatment fails clinically, suggesting a diverse role for TGF-β1 in DKD. In the present study, we examined a novel hypothesis that latent TGF-β1 may be protective in DKD mice overexpressing human latent TGF-β1. Streptozotocin-induced Type 1 diabetes was induced in latent TGF-β1 transgenic (Tg) and wild-type (WT) mice. Surprisingly, compared to WT diabetic mice, mice overexpressing latent TGF-β1 were protected from the development of DKD as demonstrated by lowing microalbuminuria and inhibiting renal fibrosis and inflammation, although blood glucose levels were not altered. Mechanistically, the renal protective effects of latent TGF-β1 on DKD were associated with inactivation of both TGF-β/Smad and nuclear factor-κB (NF-κB) signaling pathways. These protective effects were associated with the prevention of renal Smad7 from the Arkadia-induced ubiquitin proteasomal degradation in the diabetic kidney, suggesting protection of renal Smad7 from Arkadia-mediated degradation may be a key mechanism through which latent TGF-β1 inhibits DKD. This was further confirmed in vitro in mesangial cells that knockdown of Arkadia failed but overexpression of Arkadia reversed the protective effects of latent TGF-β1 on high glucose-treated mesangial cells. Latent TGF-β1 may protect kidneys from TGF-β1/Smad3-mediated renal fibrosis and NF-κB-driven renal inflammation in diabetes through inhibiting Arkadia-mediated Smad7 ubiquitin degradation.