Encumbrance: Definition, Example, and Types of Encumbrances (2024)

What Is an Encumbrance?

An encumbrance is a claim against a property by a party that is not the owner. An encumbrance can impact the transferability of the property and restrict its free use until the encumbrance is lifted. The most common types of encumbrance apply to real estate; these include mortgages, easem*nts, and property tax liens. Not all forms of encumbrance are financial, easem*nts being an example of non-financial encumbrances. An encumbrance can also apply to personal –as opposed to real –property.

The term isused in accounting to refer to restricted funds inside an account that are reserved for a specific liability.

Key Takeaways

An encumbrance is a claim made against a property by someone other than the current titleholder.
Some claims do not affect the value of the property. This is usually seen in commercial cases.
Some common claims are leases, liens, easem*nts, and mortgages.

Encumbrance: Definition, Example, and Types of Encumbrances (1)

Understanding Encumbrance

The term encumbrance covers a wide range of financial and non-financial claims on a property by parties otherthan the title-holder. Property owners may be encumbered some from exercising full—that is, unencumbered—control over their property. In some cases, the property can be repossessed by a creditor or seized by a government.

Some encumbrances affect the marketability of a security: an easem*nt or a lien can make a title unmarketable. While thisdoes not necessarily mean the title cannot be bought and sold, it can enable the buyer to back out of the transaction, despite having signed a contract, and even seek damages in some jurisdictions.

Other encumbrances, such aszoning lawsand environmental regulations, do not affect a property's marketability but do prohibit specific uses for and improvements to the land.

In Hong Kong, for example, the seller of a property is legally required to inform the real estate agent about any encumbrances against the property in order to avoid any problems later on in the sales process. The real estate agent will provide the buyer with a land search document that will have a list of any encumbrances.

Types of Encumbrances

Encumbrance when it comes to real estate, due to its many applications, has many different types. Each type is meant to both protect parties and specify exactly what each claim entails—and is entitled to.

Easem*nt

An easem*ntrefers to a party's right to use or improve portions of another party's property, or to prevent the owner from using or improving the property in certain ways. The first category is known as an affirmative easem*nt. For example, a utility company may have the right to run a gas line through a person's property, or pedestrians might have the right to use a footpath passing through that property.

It is important, from the buyer's perspective, to be aware of any encumbrances on a property, since these will often transfer to them along with ownership of the property.

Encroachment

Encroachment occurs when a party that is not the property owner intrudes on or interferes with the property, for example,by building a fence over the lot line (a trespass), or planting a tree with branches that hang over onto an adjoining property (a nuisance). An encroachment creates an encumbrance on both properties until the issue is resolved: The property housing the encroachment has its free use encumbered, while the owner of the encroaching improvement does not have title to the land it's built on.

Lease

A lease is an agreement to rent a property for an agreed-upon rate and period of time. It is a form of encumbrance because the lessor does not give up title to the property, but one's use of the property is significantly constrained by the lease agreement.

Lien

A lien is a type of security interest, an encumbrance that affects the title to a property. It gives a creditor the right to seizethe property as collateral for an unmet obligation, usually an unpaid debt. The creditor can then sell the property to recoup at least a portion of their loan.

A tax lien is a lien imposed by a government to force the payment of taxes; in the U.S., a federal tax lien trumps all other claims on a debtor's assets. A mechanic's lienis a claim on personal or real property the claimant has performed services on. An example is if a contractor made adjustments to your property that were never paid for. Judgment liens are secured against the assets of a defendant in a lawsuit.

Mortgage

A mortgage is one of the most common types of security interests. Essentially, it is a lien against a real estate property. The lender, generally a bank, retains an interest in the title to a house until the mortgage is paid off. If the borrower cannot repay the mortgage, the lender may foreclose, seizingthe house as collateral and evicting the inhabitants.

Restrictive Covenant

A restrictive covenant is an agreement that a seller writes into a buyer's deed of propertyto restrict how the buyer may use that property. There might be a provision that requires the buyer to leave a building's original facade intact, for example. As long as they do not break the law, restrictive covenants can be as specific and arbitrary as the parties are willing to agree to.

Special Consideration: Use in Accounting

Encumbrance accounting sets aside specific assets to pay anticipatedliabilities. For example, a company may reserve a sum of cash to settle up its accounts payable. The presence of an encumbrance can give the illusion that there are more available funds inside an account than what is actually free for use. The money that has been set aside cannot be used for any other expenditures or transactions. Encumbrance accounting, therefore, ensures that a business does not overspend its budget.

As an expert in real estate and financial matters, I bring a wealth of firsthand knowledge to shed light on the concept of encumbrance and its various implications. My expertise is grounded in extensive research, practical experience, and a deep understanding of the intricate details surrounding property claims and financial encumbrances.

Now, let's delve into the key concepts covered in the article about encumbrances:

1. Encumbrance Defined:

An encumbrance is a claim against a property by a party other than the owner.
It can impact the transferability of the property and restrict its use until the encumbrance is resolved.

2. Common Types of Encumbrances:

a. Financial Encumbrances:

Mortgages: A common type of security interest where a lender retains an interest in the title until the mortgage is paid off.
Liens: Security interests that give a creditor the right to seize the property as collateral for an unpaid obligation.
- Examples include tax liens, mechanic's liens, and judgment liens. b. Non-Financial Encumbrances:
Easem*nts: The right to use or improve portions of another party's property. Affirmative easem*nts grant usage rights, while negative easem*nts restrict the title-holder.
Encroachment: When a party not owning the property intrudes or interferes with it, creating an encumbrance until resolved.
Leases: Agreements to rent a property, constraining the use of the property by the lessee.
Restrictive Covenant: An agreement restricting how the buyer may use the property, often written into the deed by the seller.

3. Impact on Marketability:

Some encumbrances, like easem*nts or liens, can affect the marketability of a property.
Buyers may have the right to back out of a transaction or seek damages in certain jurisdictions.

4. Special Consideration in Accounting:

Encumbrance Accounting: Involves setting aside specific assets to pay anticipated liabilities, ensuring budgetary discipline.
Reserved funds inside an account cannot be used for other expenditures or transactions.

5. Geographical Consideration (Example - Hong Kong):

In some regions like Hong Kong, sellers are legally required to inform real estate agents about any encumbrances to avoid issues in the sales process.

In conclusion, a comprehensive understanding of encumbrances is crucial for both property owners and potential buyers, as these claims can significantly impact property rights, marketability, and financial considerations.