If the settlement is not considered taxable income, you can't deduct your expenses. If the settlement is considered taxable income, then you deduct your legal expenses as a miscellaneous itemized deduction subject to the 2% rule on schedule A.
Legal settlements are taxable or non-taxable based on the character of the income that they represent. For example, a settlement for lost wages is taxable because wages are taxable. A settlement for physical injury or physical damages to property is not taxable, However, if part of the settlement includes punitive damages or damages for pain and suffering, that is taxable.
