A construction contractor defrauded me and embezzled our money from the get-go using a stolen construction license, forged construction permits, collected money without supplying goods such as cabinets, doors, electrical, sewage, paint, pretty much everything and ran away. The California License Board investigated the fraud and as soon as he learned about having been caught defrauding, he disappeared. The Attorney General issued an arrest warrant for not appearing for hearing. I filed a civil lawsuit. I understand the IRS allows deduction for fraud using IRS form 515 but the form does not have any section that allows deduction. Can I and how to deduct this loss?
What you want is called "non-business bad debt." This is taken a capital loss on schedule D. You can deduct your loss up to the amount of any capital gains plus $3000, and carry the rest of the loss forward until it is used up.
The key point here is that you must have a final determination that the debt is completely worthless. Since you have a lawsuit pending, and possible criminal charges, you don't have a final determination. That final determination might come after you get a civil judgment, then file collection proceedings, and the collections agency tells you the debt is non-collectible. Or, maybe the contractor declares bankruptcy and you get 10% back. At that point you could claim a loss on the other 90%.
It's important to note that the bad debt is only what you paid out of your own pockets and didn't get fair value for. For example, if they promised to renovate your kitchen for $40,000, and you paid $20,000 and they skipped, your loss is $20,000. Even if it takes $50,000 for a new contractor to do it properly, your loss is only the $20,000 you paid out, not the increased cost of doing it right. You also can't deduct loss profits or lost income -- if this was to build a mother-in-law apartment that you planned to rent, you can't deduct speculative lost rent you never received. (Your tax "reduction" is that since you don't have income, you don't pay tax on it.)
There are some other requirements, you can read more here.
https://www.irs.gov/taxtopics/tc453