The IRS says it stopped inmates from illegally claiming $2.5 billion in tax refunds in the 2012 budget year. About $1.1 billion was trying to be claimed by just two inmates.
The report credits the IRS and prison officials with stepping up enforcement and sharing more information, but it says more can be done to stop tax fraud among inmates.
"Refund fraud committed by prisoners remains a significant problem for tax administration," said J. Russell George, the Treasury's inspector general for tax administration.
The heavily redacted report contains few details about inmates' scams and no information about how two prisoners thought they could get the federal government to send them more than $1 billion. Tax information, even for inmates, is private by law, unless a person gets charged with a crime.
The IRS says it aggressively prosecutes tax fraud.
Over the years, investigators have found that crafty inmates will go to great lengths to try to steal identities or trick the IRS into sending them a refund they don't deserve, said inspector general spokeswoman Karen Kraushaar.
Some inmates scour obituaries, looking for identities to steal. Others use the identities of fellow inmates or even their own. Some use their access to computers to file tax returns online. They can have refunds electronically deposited into the bank accounts of friends on the outside.
Some inmates have identified businesses that have filed for bankruptcy and claimed to work there, using the bankruptcy as an excuse for why the company didn't send them a W-2 form.
In 2010, the inspector general's office found that nearly 50,000 prison inmates claimed more than $130 million in tax refunds without providing any wage information to the IRS, according to a 2010 audit. That same year, the office found that nearly 1,300 prison inmates had improperly received more than $9 million in homebuyer tax credits while they were locked up.
"Most taxpayers find e-filing to be quick and easy. Unfortunately, some bad guys have also found it a quick and easy way to commit fraud," Kraushaar said.
Prison inmates may have legitimate reasons to file tax returns and get refunds, especially if they are newly incarcerated or have investment income. However, the IRS gives special scrutiny to returns from inmates, when the agency is able to identify them, said IRS spokeswoman Michelle Eldridge.