Meanwhile, the company is predicting nearly 1 million more mortgage borrowers will emerge from negative equity in 2013.
Almost 28% of borrowers were underwater in 4Q12, or 13.8 million people, versus 31%, or 15.7 million people, in the year prior.
The primary driver of the reduction was a near 6% rise in home values on a national basis, along with sustained high foreclosure rates, Zillow said. Between those two events, Phoenix had 135,099 homeowners (or former homeowners) no longer in a negative equity position for the year, followed by Los Angeles (72,936), Miami-Fort Lauderdale (70,484), Dallas-Fort Worth (59,461) and Riverside, Calif. (58,417).
By the fourth quarter of 2013, Zillow predicts the negative equity rate will fall to almost 26%.
"As home values continue to rise and more homeowners are pulled out of negative equity in 2013, the positive effects on the housing market will be numerous. Freed from negative equity, homeowners will have more flexibility, and some will likely choose to list their home for sale, helping to ease inventory constraints and moderating sometimes dramatic, demand-driven price increases in some markets," said Zillow chief economist Stan Humphries.
"But negative equity is still very high, and millions of homeowners have a very long way to go to get back above water, even with current robust levels of home value appreciation in most areas. As a result, negative equity will remain a major factor in the market for the foreseeable future."
Zillow is projecting that in two markets, Chicago and St. Louis, there will be an increase in the number of mortgage borrowers in a negative equity position at the end of this year.
Las Vegas will see 8,062 fewer homeowners underwater by the end of this year. The state is talking about buying underwater loans from the Federal Housing Administration and refinancing them.