diff --git a/e2e/tests/extends/extends.go b/e2e/tests/extends/extends.go
index 2e37e973b..6706f2d97 100644
--- a/e2e/tests/extends/extends.go
+++ b/e2e/tests/extends/extends.go
@@ -300,6 +300,129 @@ var _ = ginkgo.Describe("extends property", ginkgo.Label("extends"), func() {
 				gomega.HaveKey("ghcr.io/devcontainers/features/go:1"),
 			)
 		}, ginkgo.SpecTimeout(framework.TimeoutShort()))
+
+	ginkgo.It(
+		"resolves ${localEnv:VAR} variable substitution in extends path",
+		ginkgo.Label("extends"),
+		func(ctx context.Context) {
+			f := framework.NewDefaultFramework(initialDir + "/bin")
+			tempDir, err := framework.CopyToTempDirWithoutChdir(
+				"tests/extends/testdata/varsub-localenv",
+			)
+			framework.ExpectNoError(err)
+			ginkgo.DeferCleanup(func() { _ = os.RemoveAll(tempDir) })
+
+			gomega.Expect(os.Setenv("TEST_EXTENDS_DIR", tempDir)).To(gomega.Succeed())
+			ginkgo.DeferCleanup(func() {
+				gomega.Expect(os.Unsetenv("TEST_EXTENDS_DIR")).To(gomega.Succeed())
+			})
+
+			stdout, _, err := readConfiguration(ctx, f, tempDir)
+			framework.ExpectNoError(err)
+
+			config := parseConfigFromOutput(stdout)
+			gomega.Expect(config).To(
+				gomega.HaveKeyWithValue("name", "LocalEnv Extends Child"),
+			)
+			gomega.Expect(config).To(
+				gomega.HaveKeyWithValue(
+					"image",
+					"ghcr.io/devsy-org/test-images/base:ubuntu",
+				),
+			)
+			gomega.Expect(config).To(gomega.HaveKeyWithValue("remoteUser", "vscode"))
+
+			containerEnv, ok := config["containerEnv"].(map[string]any)
+			gomega.Expect(ok).To(gomega.BeTrue(), "containerEnv should be an object")
+			gomega.Expect(containerEnv).To(
+				gomega.HaveKeyWithValue("FROM_PARENT", "parent-value"),
+			)
+		}, ginkgo.SpecTimeout(framework.TimeoutShort()))
+
+	ginkgo.It(
+		"resolves ${localWorkspaceFolder} variable substitution in extends path",
+		ginkgo.Label("extends"),
+		func(ctx context.Context) {
+			f := framework.NewDefaultFramework(initialDir + "/bin")
+			tempDir, err := framework.CopyToTempDirWithoutChdir(
+				"tests/extends/testdata/varsub-workspace-folder",
+			)
+			framework.ExpectNoError(err)
+			ginkgo.DeferCleanup(func() { _ = os.RemoveAll(tempDir) })
+
+			stdout, _, err := readConfiguration(ctx, f, tempDir)
+			framework.ExpectNoError(err)
+
+			config := parseConfigFromOutput(stdout)
+			gomega.Expect(config).To(
+				gomega.HaveKeyWithValue("name", "Workspace Folder Extends Child"),
+			)
+			gomega.Expect(config).To(
+				gomega.HaveKeyWithValue(
+					"image",
+					"ghcr.io/devsy-org/test-images/base:ubuntu",
+				),
+			)
+			gomega.Expect(config).To(gomega.HaveKeyWithValue("remoteUser", "vscode"))
+
+			containerEnv, ok := config["containerEnv"].(map[string]any)
+			gomega.Expect(ok).To(gomega.BeTrue(), "containerEnv should be an object")
+			gomega.Expect(containerEnv).To(
+				gomega.HaveKeyWithValue("FROM_PARENT", "workspace-parent-value"),
+			)
+		}, ginkgo.SpecTimeout(framework.TimeoutShort()))
+
+	ginkgo.It(
+		"resolves ${localEnv:VAR:default} with fallback when env var is unset",
+		ginkgo.Label("extends"),
+		func(ctx context.Context) {
+			f := framework.NewDefaultFramework(initialDir + "/bin")
+			tempDir, err := framework.CopyToTempDirWithoutChdir(
+				"tests/extends/testdata/varsub-localenv-default",
+			)
+			framework.ExpectNoError(err)
+			ginkgo.DeferCleanup(func() { _ = os.RemoveAll(tempDir) })
+
+			gomega.Expect(os.Unsetenv("DEVSY_UNSET_VAR")).To(gomega.Succeed())
+
+			stdout, _, err := readConfiguration(ctx, f, tempDir)
+			framework.ExpectNoError(err)
+
+			config := parseConfigFromOutput(stdout)
+			gomega.Expect(config).To(
+				gomega.HaveKeyWithValue("name", "LocalEnv Default Extends Child"),
+			)
+			gomega.Expect(config).To(
+				gomega.HaveKeyWithValue(
+					"image",
+					"ghcr.io/devsy-org/test-images/base:ubuntu",
+				),
+			)
+			gomega.Expect(config).To(gomega.HaveKeyWithValue("remoteUser", "vscode"))
+
+			containerEnv, ok := config["containerEnv"].(map[string]any)
+			gomega.Expect(ok).To(gomega.BeTrue(), "containerEnv should be an object")
+			gomega.Expect(containerEnv).To(
+				gomega.HaveKeyWithValue("FROM_FALLBACK", "fallback-value"),
+			)
+		}, ginkgo.SpecTimeout(framework.TimeoutShort()))
+
+	ginkgo.It(
+		"returns error when ${localEnv:VAR} resolves to empty for missing env var",
+		ginkgo.Label("extends"),
+		func(ctx context.Context) {
+			f := framework.NewDefaultFramework(initialDir + "/bin")
+			tempDir, err := framework.CopyToTempDirWithoutChdir(
+				"tests/extends/testdata/varsub-localenv-missing",
+			)
+			framework.ExpectNoError(err)
+			ginkgo.DeferCleanup(func() { _ = os.RemoveAll(tempDir) })
+
+			gomega.Expect(os.Unsetenv("DEVSY_NONEXISTENT_VAR")).To(gomega.Succeed())
+
+			_, _, err = readConfiguration(ctx, f, tempDir)
+			framework.ExpectError(err)
+		}, ginkgo.SpecTimeout(framework.TimeoutShort()))
 })
 
 func pushOCIImage(refStr, jsonContent string) {
diff --git a/e2e/tests/extends/testdata/varsub-localenv-default/.devcontainer/devcontainer.json b/e2e/tests/extends/testdata/varsub-localenv-default/.devcontainer/devcontainer.json
new file mode 100644
index 000000000..f4eb55897
--- /dev/null
+++ b/e2e/tests/extends/testdata/varsub-localenv-default/.devcontainer/devcontainer.json
@@ -0,0 +1,4 @@
+{
+  "extends": "${localEnv:DEVSY_UNSET_VAR:fallback}/devcontainer.json",
+  "name": "LocalEnv Default Extends Child"
+}
diff --git a/e2e/tests/extends/testdata/varsub-localenv-default/.devcontainer/fallback/devcontainer.json b/e2e/tests/extends/testdata/varsub-localenv-default/.devcontainer/fallback/devcontainer.json
new file mode 100644
index 000000000..7c1f881c7
--- /dev/null
+++ b/e2e/tests/extends/testdata/varsub-localenv-default/.devcontainer/fallback/devcontainer.json
@@ -0,0 +1,7 @@
+{
+  "image": "ghcr.io/devsy-org/test-images/base:ubuntu",
+  "remoteUser": "vscode",
+  "containerEnv": {
+    "FROM_FALLBACK": "fallback-value"
+  }
+}
diff --git a/e2e/tests/extends/testdata/varsub-localenv-missing/.devcontainer/devcontainer.json b/e2e/tests/extends/testdata/varsub-localenv-missing/.devcontainer/devcontainer.json
new file mode 100644
index 000000000..7ebe2d02f
--- /dev/null
+++ b/e2e/tests/extends/testdata/varsub-localenv-missing/.devcontainer/devcontainer.json
@@ -0,0 +1,4 @@
+{
+  "extends": "${localEnv:DEVSY_NONEXISTENT_VAR}/devcontainer.json",
+  "name": "Missing Env Var Child"
+}
diff --git a/e2e/tests/extends/testdata/varsub-localenv/.devcontainer/devcontainer.json b/e2e/tests/extends/testdata/varsub-localenv/.devcontainer/devcontainer.json
new file mode 100644
index 000000000..6988ba345
--- /dev/null
+++ b/e2e/tests/extends/testdata/varsub-localenv/.devcontainer/devcontainer.json
@@ -0,0 +1,4 @@
+{
+  "extends": "${localEnv:TEST_EXTENDS_DIR}/parent/devcontainer.json",
+  "name": "LocalEnv Extends Child"
+}
diff --git a/e2e/tests/extends/testdata/varsub-localenv/parent/devcontainer.json b/e2e/tests/extends/testdata/varsub-localenv/parent/devcontainer.json
new file mode 100644
index 000000000..85f4a0dfc
--- /dev/null
+++ b/e2e/tests/extends/testdata/varsub-localenv/parent/devcontainer.json
@@ -0,0 +1,7 @@
+{
+  "image": "ghcr.io/devsy-org/test-images/base:ubuntu",
+  "remoteUser": "vscode",
+  "containerEnv": {
+    "FROM_PARENT": "parent-value"
+  }
+}
diff --git a/e2e/tests/extends/testdata/varsub-workspace-folder/.devcontainer/configs/parent/devcontainer.json b/e2e/tests/extends/testdata/varsub-workspace-folder/.devcontainer/configs/parent/devcontainer.json
new file mode 100644
index 000000000..8035b52b9
--- /dev/null
+++ b/e2e/tests/extends/testdata/varsub-workspace-folder/.devcontainer/configs/parent/devcontainer.json
@@ -0,0 +1,7 @@
+{
+  "image": "ghcr.io/devsy-org/test-images/base:ubuntu",
+  "remoteUser": "vscode",
+  "containerEnv": {
+    "FROM_PARENT": "workspace-parent-value"
+  }
+}
diff --git a/e2e/tests/extends/testdata/varsub-workspace-folder/.devcontainer/devcontainer.json b/e2e/tests/extends/testdata/varsub-workspace-folder/.devcontainer/devcontainer.json
new file mode 100644
index 000000000..69ffd3669
--- /dev/null
+++ b/e2e/tests/extends/testdata/varsub-workspace-folder/.devcontainer/devcontainer.json
@@ -0,0 +1,4 @@
+{
+  "extends": "${localWorkspaceFolder}/configs/parent/devcontainer.json",
+  "name": "Workspace Folder Extends Child"
+}
diff --git a/pkg/devcontainer/config/extends_test.go b/pkg/devcontainer/config/extends_test.go
index 18e89113f..f3f8af3be 100644
--- a/pkg/devcontainer/config/extends_test.go
+++ b/pkg/devcontainer/config/extends_test.go
@@ -678,6 +678,152 @@ func TestExtendsRef_MarshalJSON(t *testing.T) {
 	}
 }
 
+func TestExtends_LocalEnvInPath(t *testing.T) {
+	tmpDir := t.TempDir()
+	writeJSON(t, tmpDir, "parent.json", `{
+		"name": "parent",
+		"image": "ubuntu:20.04"
+	}`)
+
+	childDir := filepath.Join(tmpDir, "child")
+	// #nosec G301 -- test directory
+	if err := os.MkdirAll(childDir, 0o750); err != nil {
+		t.Fatal(err)
+	}
+
+	t.Setenv("TEST_EXTENDS_DIR", tmpDir)
+	writeJSON(t, childDir, "child.json", `{
+		"extends": "${localEnv:TEST_EXTENDS_DIR}/parent.json",
+		"name": "child"
+	}`)
+
+	cfg, err := ParseDevContainerJSONFile(filepath.Join(childDir, "child.json"))
+	if err != nil {
+		t.Fatal(err)
+	}
+	if cfg.Name != testNameChild {
+		t.Errorf("expected name 'child', got %q", cfg.Name)
+	}
+	if cfg.Image != testImageUbuntu {
+		t.Errorf("expected image 'ubuntu:20.04', got %q", cfg.Image)
+	}
+}
+
+func TestExtends_LocalWorkspaceFolderInPath(t *testing.T) {
+	tmpDir := t.TempDir()
+
+	configsDir := filepath.Join(tmpDir, "configs")
+	// #nosec G301 -- test directory
+	if err := os.MkdirAll(configsDir, 0o750); err != nil {
+		t.Fatal(err)
+	}
+	writeJSON(t, configsDir, "parent.json", `{
+		"name": "parent",
+		"image": "node:18"
+	}`)
+
+	writeJSON(t, tmpDir, "child.json", `{
+		"extends": "${localWorkspaceFolder}/configs/parent.json",
+		"name": "child"
+	}`)
+
+	cfg, err := ParseDevContainerJSONFile(filepath.Join(tmpDir, "child.json"))
+	if err != nil {
+		t.Fatal(err)
+	}
+	if cfg.Name != testNameChild {
+		t.Errorf("expected name 'child', got %q", cfg.Name)
+	}
+	if cfg.Image != "node:18" {
+		t.Errorf("expected image 'node:18', got %q", cfg.Image)
+	}
+}
+
+func TestExtends_MissingEnvResolvesToEmpty(t *testing.T) {
+	tmpDir := t.TempDir()
+	writeJSON(t, tmpDir, "child.json", `{
+		"extends": "${localEnv:NONEXISTENT_VAR_FOR_TEST}/parent.json",
+		"name": "child"
+	}`)
+
+	_, err := ParseDevContainerJSONFile(filepath.Join(tmpDir, "child.json"))
+	if err == nil {
+		t.Fatal("expected error due to invalid path from empty env var")
+	}
+	if strings.Contains(err.Error(), "${localEnv:") {
+		t.Errorf(
+			"variable should have been substituted (resolved to empty), but got literal: %v",
+			err,
+		)
+	}
+}
+
+func TestExtends_LocalEnvDefaultValue(t *testing.T) {
+	tmpDir := t.TempDir()
+
+	fallbackDir := filepath.Join(tmpDir, "fallback")
+	// #nosec G301 -- test directory
+	if err := os.MkdirAll(fallbackDir, 0o750); err != nil {
+		t.Fatal(err)
+	}
+	writeJSON(t, fallbackDir, "parent.json", `{
+		"name": "parent",
+		"image": "debian:12"
+	}`)
+
+	t.Setenv("UNSET_VAR_FOR_EXTENDS_TEST", "")
+	if err := os.Unsetenv("UNSET_VAR_FOR_EXTENDS_TEST"); err != nil {
+		t.Fatal(err)
+	}
+
+	writeJSON(t, tmpDir, "child.json", `{
+		"extends": "${localEnv:UNSET_VAR_FOR_EXTENDS_TEST:fallback}/parent.json",
+		"name": "child"
+	}`)
+
+	cfg, err := ParseDevContainerJSONFile(filepath.Join(tmpDir, "child.json"))
+	if err != nil {
+		t.Fatal(err)
+	}
+	if cfg.Name != testNameChild {
+		t.Errorf("expected name 'child', got %q", cfg.Name)
+	}
+	if cfg.Image != "debian:12" {
+		t.Errorf("expected image 'debian:12', got %q", cfg.Image)
+	}
+}
+
+func TestExtends_LocalWorkspaceFolderBasenameInPath(t *testing.T) {
+	tmpDir := t.TempDir()
+	basename := filepath.Base(tmpDir)
+
+	parentDir := filepath.Join(tmpDir, basename)
+	// #nosec G301 -- test directory
+	if err := os.MkdirAll(parentDir, 0o750); err != nil {
+		t.Fatal(err)
+	}
+	writeJSON(t, parentDir, "parent.json", `{
+		"name": "parent",
+		"image": "alpine:3"
+	}`)
+
+	writeJSON(t, tmpDir, "child.json", `{
+		"extends": "${localWorkspaceFolder}/${localWorkspaceFolderBasename}/parent.json",
+		"name": "child"
+	}`)
+
+	cfg, err := ParseDevContainerJSONFile(filepath.Join(tmpDir, "child.json"))
+	if err != nil {
+		t.Fatal(err)
+	}
+	if cfg.Name != testNameChild {
+		t.Errorf("expected name 'child', got %q", cfg.Name)
+	}
+	if cfg.Image != "alpine:3" {
+		t.Errorf("expected image 'alpine:3', got %q", cfg.Image)
+	}
+}
+
 func strPtr(s string) *string {
 	return &s
 }
diff --git a/pkg/devcontainer/config/parse.go b/pkg/devcontainer/config/parse.go
index d81aeb977..aa7816007 100644
--- a/pkg/devcontainer/config/parse.go
+++ b/pkg/devcontainer/config/parse.go
@@ -101,6 +101,12 @@ func ParseDevContainerJSONFile(jsonFilePath string) (*DevContainerConfig, error)
 	if !devContainer.Extends.IsEmpty() {
 		visited := map[string]bool{path: true}
 		declaringDir := filepath.Dir(path)
+
+		replacer := extendsVarReplacer(declaringDir)
+		for i, ref := range devContainer.Extends {
+			devContainer.Extends[i] = ResolveString(ref, replacer)
+		}
+
 		parent, err := resolveExtendsArray(
 			context.TODO(),
 			devContainer.Extends,
@@ -284,6 +290,33 @@ func Convert(from any, to any) error {
 	return json.Unmarshal(out, to)
 }
 
+// extendsVarReplacer returns a ReplaceFunction that resolves only local-scope
+// variables suitable for use before the container exists.
+func extendsVarReplacer(localWorkspaceFolder string) ReplaceFunction {
+	return func(match, variable string, args []string) string {
+		switch variable {
+		case varLocalEnv:
+			if len(args) > 0 {
+				val, ok := os.LookupEnv(args[0])
+				if ok {
+					return val
+				}
+				if len(args) > 1 {
+					return strings.Join(args[1:], ":")
+				}
+				return ""
+			}
+			return match
+		case varLocalWorkspaceFolder:
+			return localWorkspaceFolder
+		case "localWorkspaceFolderBasename":
+			return filepath.Base(localWorkspaceFolder)
+		default:
+			return match
+		}
+	}
+}
+
 func ParseKeyValueFile(filename string) ([]string, error) {
 	f, err := os.Open(filename)
 	if err != nil {
diff --git a/pkg/devcontainer/config/substitute.go b/pkg/devcontainer/config/substitute.go
index 6d8e8c2a6..cd84ae883 100644
--- a/pkg/devcontainer/config/substitute.go
+++ b/pkg/devcontainer/config/substitute.go
@@ -20,6 +20,9 @@ const (
 
 	LabelLocalFolder = "devcontainer.local_folder"
 	LabelConfigFile  = "devcontainer.config_file"
+
+	varLocalEnv             = "localEnv"
+	varLocalWorkspaceFolder = "localWorkspaceFolder"
 )
 
 type ReplaceFunction func(match, variable string, args []string) string
@@ -147,9 +150,9 @@ func replaceWithContext(
 			return substitutionCtx.DevContainerID
 		}
 		return match
-	case "localEnv":
+	case varLocalEnv:
 		return lookupValue(isWindows, substitutionCtx.Env, args, match)
-	case "localWorkspaceFolder":
+	case varLocalWorkspaceFolder:
 		if substitutionCtx.LocalWorkspaceFolder != "" {
 			return substitutionCtx.LocalWorkspaceFolder
 		}