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Big data used to catch fraudulent tax returns

Identity thieves are stealing billions of dollars a year through fraudulent tax refunds—and the IRS isn't the only target. The 43 states that collect an income tax are also being flooded with these bogus returns.

How serious is the problem?

A report from the Treasury inspector general for tax administration estimated that fraudulent tax refunds resulting from identity theft totaled about $3.6 billion for the 2011 tax filing season. That's down by $1.6 billion from the previous year due to better detection, but the report says the ongoing problem creates "devastating consequences for taxpayers" that "erodes their confidence" in the federal tax system.

At the state level, the resources simply aren't there to tackle this problem. Some revenue collection offices have put procedures in place to spot the most obvious warning signs of fraud, such as too many returns to the same address or bank account, but a lot still slips through.

Floortje | E+ | Getty Images

"This is a fixable problem, but you need the technology to fix it and most states are not technologically equipped to deal with this," said Howard Safir, former commissioner of the New York Police Department.

Georgia, Indiana and Louisiana now contract with LexisNexis Risk Solutions to screen all of their returns against its massive database of public information.

"If we can stop it on the front end, it's way better than trying to clean it up on the back end," said Douglas MacGinnitie, commissioner of the Georgia Department of Revenue.

When LexisNexis finds a suspicious return, it's flagged and set aside. A letter is automatically sent to the taxpayer instructing them to go online and answer a few simple multiple choice questions to verify their identity. The questions cover information an identity thief wouldn't likely know. For example: Which of these addresses did you live at or which one of these cars did you own?

Georgia started using LexisNexis for the 2011 filing season. It paid the company $3 million to filter all of its returns, and the system caught $25 million worth of fraudulent refunds.

"That's a pretty good return in any business," MacGinnitie said. "We really could not do this on our own."

(Read more: Confused about taxes? Answers to tricky questions)

The system does create false positives—legitimate returns that are flagged as suspicious, and that can slow down a refund for a least a few days. But MacGinnitie, whose wife was a victim of tax ID fraud, believes it's a reasonable trade-off.

"I think most taxpayers appreciate that we have to balance speed versus accuracy and they're willing to trade off a little bit of speed to save millions of tax dollars," he said.

How does it work?

"We've created 32 algorithms based on public record content that compare this information with the information that's on a tax return," said Haywood Talcove, of LexisNexis special services. "And we can very quickly deduce if it doesn't make sense."

For example, the software can catch a nonexistent address, a nonresidential address or an address that just doesn't compute. Let's say you live in Seattle and try to file a return in New York. If the software doesn't find any records showing you moved, it would kick out your return.

(Read more: Why some of us are more vulnerable to online fraud)

"We're finding that about 3 to 5 percent of all refunds are fraudulent, depending on the state," Talcove said.

Indiana just started using the service this year. Its revenue commissioner, Mike Alley, believes they catch about half the fraud on their own. He hopes the new screening will catch most of the rest and save his state tens of millions of dollars.

"This program very efficiently and pretty quickly, without slowing down the refund process, allows us to identify those culprits," Alley said. "It's increased our efficiency and enabled us to pursue other forms of tax fraud."

So far, Indiana has identified more than 750 fraudulent returns worth $1.4 million.

It's not rocket science

It doesn't take a brilliant criminal mind to commit tax fraud. All a crook needs is some basic information—a Social Security number and possibly a W-2 form—to file a false return.

"Tax fraud is easy," said Ray, a convicted identity thief serving a long prison sentence in California. "You can just go through mailboxes and there's a lot of W-2's out there."

Ray, who did not want his last name used, was interviewed for "In the Company of Thieves," a series of videos produced by the nonprofit Identity Theft Council. He tells security expert Neal O'Farrell that he once used a stolen identity and false return—filled with bogus deductions and credits–to get a $15,000 refund.

O'Farrell says Ray was laughing about another scam he pulled. He couldn't understand why a return that listed deductions for five kids didn't set off any alarms, when the year before he didn't have any kids.

(Read more: Why do we hate debt collectors? Mistaken identity)

"ID tax fraud has been the most attractive type of identity theft for years now, which is why the dumbest of the dumb criminals got in on this," O'Farrell said. "You can't criticize thieves for taking advantage of stupid, and it was breathtakingly stupid that the IRS and the states didn't invest in simple measures that would eliminate 90 percent of this fraud."

Protect yourself

We're all vulnerable to this crime, but there are things you can do that will reduce your risk of becoming a victim.

  • If you file by mail, do it at a post office, not from an unlocked mailbox in front of your house.
  • If you file electronically, use a secure computer on a secure network.
  • If your employer offers this option, ask to have your W-2 emailed to you.

Your identity may have been stolen if you get a letter from the IRS that says more than one tax return was filed for you or that you received wages from an employer you don't know. Respond immediately. The IRS has a special unit dedicated to ID Tax fraud: 800-908-4490.

More Information:

—By CNBC contributor Herb Weisbaum. Follow him on Facebook and Twitter @TheConsumerman or visit The ConsumerMan website.

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