I disagree, however the actual answer is “not yet.”
If this is a theft loss, it is not deductible, as stated.
If this is a non-business bad debt, then it is a deductible capital loss on schedule D, but it is only deductible when the loss is realized and all reasonable efforts at collection have failed. If you are in the process of suing the contractor, all reasonable steps to collect the debt have not yet failed. You would have to sue the contractor, win in court, place the debt in collections, and then be unable to collect, such as because the contractor goes bankrupt. You can then deduct the amount of your loss on schedule D. As a capital loss, you can deduct up to the amount of your capital gains during the year, plus $3000. If you don’t have other capital gains, such as from the sale of stocks or mutual funds, then you will only be able to deduct $3000 per year and can carry the remaining debt forward year over year until you use it up.
Also, your legal expenses are not deductible, only the amount of the capital loss.
The distinction between a bad debt and a theft loss is tricky. In the past, it was possible to deduct most of the theft loss in the year the theft occurred, while a bad debt may only be deducted up to the amount of capital gains plus$3000, so taxpayers often preferred to take a theft loss instead of a bad debt loss. This led to some audits and some rulings on the concept of theft versus bad debt. Now the situation is turned around because theft losses are disallowed but bad debts are still allowed. I think the key here is that you were in a legitimate business relationship with the contractor. Presumably this is a legitimate contractor that actually did complete some work for some people and then fell on hard times, or had mismanagement issues, or supplier issues, and their business failed. It’s not as though somebody came onto your property and stole an uninsured car out of your driveway. This was a legitimate business arrangement that failed. (I suppose there is a chance that if you are audited, and the IRS can show that this was never a legitimate contractor, and he breezed into town and signed a bunch of contracts and collected a bunch of money and left, and was eventually arrested and convicted on criminal theft charges, that the IRS could prove this was a nondeductible theft loss. You would have to consider all the facts and circumstances before you take the bad debt loss.)
But as I stated, a bad debt can’t be deducted until the debt is completely worthless and all reasonable collection efforts have failed.
https://www.irs.gov/taxtopics/tc453
