Recently, much attention has been given to the development of biofunctionalized nanoparticles with magnetic properties for novel biomedical imaging. Guided, smart, targeting nanoparticulate magnetic resonance imaging (MRI) contrast agents inducing high MRI signal will be valuable tools for future tissue specific imaging and investigation of molecular and cellular events. In this study, we report a new design of functionalized ultrasmall rare earth based nanoparticles to be used as a positive contrast agent in MRI. The relaxivity is compared to commercially available Gd based chelates. The synthesis, PEGylation, and dialysis of small (3-5 nm) gadolinium oxide (DEG-Gd(2)O(3)) nanoparticles are presented. The chemical and physical properties of the nanomaterial were investigated with Fourier transform infrared spectroscopy, X-ray photoelectron spectroscopy, transmission electron microscopy, and dynamic light scattering. Neutrophil activation after exposure to this nanomaterial was studied by means of fluorescence microscopy. The proton relaxation times as a function of dialysis time and functionalization were measured at 1.5 T. A capping procedure introducing stabilizing properties was designed and verified, and the dialysis effects were evaluated. A higher proton relaxivity was obtained for as-synthesized diethylene glycol (DEG)-Gd(2)O(3) nanoparticles compared to commercial Gd-DTPA. A slight decrease of the relaxivity for as-synthesized DEG-Gd(2)O(3) nanoparticles as a function of dialysis time was observed. The results for functionalized nanoparticles showed a considerable relaxivity increase for particles dialyzed extensively with r(1) and r(2) values approximately 4 times the corresponding values for Gd-DTPA. The microscopy study showed that PEGylated nanoparticles do not activate neutrophils in contrast to uncapped Gd(2)O(3). Finally, the nanoparticles are equipped with Rhodamine to show that our PEGylated nanoparticles are available for further coupling chemistry, and thus prepared for targeting purposes. The long term goal is to design a powerful, directed contrast agent for MRI examinations with specific targeting possibilities and with properties inducing local contrast, that is, an extremely high MR signal at the cellular and molecular level.