Fraud by building contractors is a distressingly common occurrence. How's this for a nightmare scenario: You agree to pay a contractor $400,000 to tear down part of your house and put on an addition. While the work is going on, you, your spouse, and five children stay with your wife's parents. The contractor tells you that the work is progressing according to schedule and you make multiple payments. Suddenly, the contractor dies. He was only 30 years old. It turns out he was a drug addict. You discover that the contractor failed to do much of the work he said had been done. Moreover, considerable damage was done to the house during construction because the contractor failed to protect it from the weather.
Naturally, you sue everybody you can. The only entity that has any money you can collect from is the deceased contractor's insurer. Unfortunately, it turns out that the insurance policy lapsed because the premiums weren't paid. In the end, you settle with the insurer for $10,000.
All this happened to James and Gaetana Urtis. They figured that at least they could deduct some of their losses from their income taxes. They claimed a $188,070 theft loss deduction--the amount they paid the contractor that they determined he had pocketed instead of doing the promised work. But, you guessed it, the IRS denied the deduction.
However, this story has a somewhat happy ending. The Urtis's appealed their case to the U.S. Tax Court and won. The court rejected the IRS's claim that the Urtis's were not entitled to a theft loss deduction because the contractor's actions did not constitute theft under state law. The contractor had committed criminal fraud when he knowingly induced the Urtis's to enter into a contract which he had no intention of carrying out. Thus, the Urtis's were entitled to a $188,070 theft loss deduction. (Urtis v. Comm'r, T.C. Memo. 2013-66.)
Uninsured losses of property due to theft are tax deductible. In the case of personal property, however, a theft loss deduction is a personal itemized deduction claimed on Schedule A. Such losses are deductible only if, and to the extent, they exceed 10% of the taxpayer's adjusted gross income. Moreover, the first $100 of such losses are not deductible.
For tax purposes, theft includes far more than a mugging or burglary. It includes "any criminal appropriation of another’s property by swindling, false pretenses, and any other form of guile." Thus, you can be entitled to theft loss where you can show that a contractor deliberately lied and deceived you to get your money.
On the other hand, you don't have a theft loss where a contractor does the promised work, but you don't like the quality. Poor workmanship is not fraud and thus does not result in a theft loss. At most, it is negligence and/or breach of contract. For this reason, the Urtis's could not claim a theft loss for the damage done to their home due to the contractor's negligence in failing to protect it from the weather during construction.
For useful advice on hiring a quality contractor, check out the Nolo article Hiring a Contractor for Home Improvements.