Magnetoencephalography (MEG) signals are influenced by skull defects. However, there is a lack of evidence of this influence during source reconstruction. Our objectives are to characterize errors in source reconstruction from MEG signals due to ignoring skull defects and to assess the ability of an exact finite element head model to eliminate such errors. A detailed finite element model of the head of a rabbit used in a physical experiment was constructed from magnetic resonance and co-registered computer tomography imaging that differentiated nine tissue types. Sources of the MEG measurements above intact skull and above skull defects respectively were reconstructed using a finite element model with the intact skull and one incorporating the skull defects. The forward simulation of the MEG signals reproduced the experimentally observed characteristic magnitude and topography changes due to skull defects. Sources reconstructed from measured MEG signals above intact skull matched the known physical locations and orientations. Ignoring skull defects in the head model during reconstruction displaced sources under a skull defect away from that defect. Sources next to a defect were reoriented. When skull defects, with their physical conductivity, were incorporated in the head model, the location and orientation errors were mostly eliminated. The conductivity of the skull defect material non-uniformly modulated the influence on MEG signals. We propose concrete guidelines for taking into account conducting skull defects during MEG coil placement and modeling. Exact finite element head models can improve localization of brain function, specifically after surgery.