Multipotent mesenchymal stem cells (MSC) are reported to be immunoprivileged as well as immunosuppressive. Hence, they are ideal candidates for allogeneic transplantation to induce regeneration of diseased tissues and organs. However, it is not known whether MSC would retain their immunoprivileged and immunomodulatory properties after differentiating into the local cell types of the transplantation site. This study sought to investigate this question with a novel New Zealand White rabbit osteogenesis model. Results showed that osteogenic cells differentiated from MSC (DOC) in vitro did not express the MHC class II molecule, were incapable of inducing allogeneic lymphocyte proliferation in mixed lymphocyte culture or generating CTL, were inhibitory in ongoing lymphocyte proliferation, and secreted anti-inflammatory cytokines (IL-10 and TGF-beta). There was a significantly higher secretion of IL-10 by DOC than that by MSC, while there was no significant difference between the TGF-beta secretion of MSC and DOC in vitro. However, after IFN-gamma treatment, TGF-beta secretion by DOC significantly decreased despite the increased production by MSC. Four weeks after local DOC implantation, despite MHC class II expression, second-set allogeneic skin rejection showed similar survival to first-set allogeneic skin rejection and DOC appeared to function as osteoblasts. In conclusion, DOC retained their immunoprivileged and immunomodulatory properties in vitro, but the latter was lost following transplantation.