Allogeneic mesenchymal stem cells (MSCs) are immunoprivileged and are being investigated in phase I and phase II clinical trials to treat different degenerative and autoimmune diseases. In spite of encouraging outcome of initial trials, the long-term poor survival of transplanted cells in the host tissue has declined the overall enthusiasm. Recent analyses of allogeneic MSCs based studies confirm that after transplantation in the hypoxic or ischemic microenvironment of diseased tissues, MSCs become immunogenic and are rejected by recipient immune system. The immunoprivilege of MSCs is preserved by absence or negligible expression of cell surface antigen, human leukocyte antigen (HLA)-DRα. We found that in normoxic MSCs, 26S proteasome degrades HLA-DRα and maintains immunoprivilege of MSCs. The exposure to hypoxia leads to inactivation of 26S proteasome and formation of immunoproteasome in MSCs, which is associated with upregulation and activation of HLA-DRα, and as a result, MSCs become immunogenic. Furthermore, inhibition of immunoproteasome formation in hypoxic MSCs preserves the immunoprivilege. Therefore, hypoxia-induced shift in the phenotype of proteasome from 26S toward immunoproteasome triggers loss of immunoprivilege of allogeneic MSCs. The outcome of the current study may provide molecular targets to plan interventions to preserve immunoprivilege of allogeneic MSCs in the hypoxic or ischemic environment.