Encumbrance - Explained
What is an Encumbrance?
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What is an Encumbrance?
An encumbrance refers to a claim that a neighboring property owner makes against the one who owns the property. This can have an immediate impact on whether the property can be transferred, and further puts limitations on its free use till the encumbrance is not waived off. The concept of encumbrance is usually applicable in the real estate industry, and it can take place in the form of easements, property tax liens, and mortgages. However, one should note that every encumbrance doesn't involve monetary or financial claims. For instance, easements is a non-monetary encumbrance. Encumbrance can also be applicable to someone's personal property. This term has a huge significance in the accounting industry where it covers restricted amounts in an account that are further kept aside for a particular liability.
How does an Encumbrance Work?
Encumbrance involves a huge array of both financial and non-financial claims made on real estate property of the parties except the owner of the property. Such claims don't allow the owner of the property to have full control over his or her own land or property. There are many cases where a creditor or the government authority takes control over the land. There are some encumbrances that may have an effect on a security's marketability. For example, a lien or an easement can convert a marketable title into an unmarketable one. However, unmarketability is this case doesn't mean that the asset loses its eligibility of being bought or sold. It simply means that the buyer can repudiate the deal, and ask for compensation in some cases, even if he or she signed an agreement. Though encumbrances like environmental laws and zoning rules don't have any effect on the marketability of a property, but they don't permit anyone to use land in a particular manner and make improvements to it. If you are buying a home, it is important for you to have information on the related property encumbrances. It is so because such encumbrances will also be transferred to you followed by the property's ownership. For instance, there are laws in Hong Kong that mandatorily ask the property seller to report any property related encumbrances to the real estate agent so as to minimize the related issues later on. After knowing about the encumbrances, the real estate agent will offer the homebuyer a land search document including all the related encumbrances. In Hong Kong, if a suicide or murder happened on the property, then it would be a matter of encumbrance. Such incidents taking place within the property boundaries negatively affect the value of the property, and that's why, it is the obligation for the real estate agent to mention the encumbrance to the potential home buyers.
Types of Encumbrances
- Easement - An easement is the right of a party to make improvements or bring the property of another person or party in use. Such easement is referred to as an affirmative easement. Say, a utility firm has the authority to make a gas line pass through a particular property, or pedestrians having the authority to walk on a footpath built around the property. An easement in gross enables a person to gain benefits, and not the property owner. Say, if Jennifer has got the right to use the garden of her neighbor, she cannot transfer the same right to someone who buys her property. In case of a negative easement, the owner is not allowed to build anything that causes disruptions to the neighbors property. For example, the title-holder constructing something that would interrupt the neighbors access to light.
- Encroachment - Encroachment takes place when a party except the land owner manipulates or enters the property in an unauthorized manner. For example, trespassing by making a fence across the parking lot, or growing trees with long branches that cause a nuisance for the neighbors property. Both the parties, the affected and the one who causes violations get affected by encroachment until they both find a feasible solution to the issue. While the land that houses encroachment faces hindrance in its free use of the property, the person who creates structures or makes improvements on the land is not entitled to do so.
- Lease - A lease refers to an agreement where a property is offered on rent for a given monthly price, and time period. It is considered an encumbrance as lessor doesn't pass the title or ownership of the property to the lessee. The extent of using the property by the lessor is mentioned in the lease agreement.
- Lien - A lien is referred to as an interest on security, that is seen as an encumbrance having an impact on the ownership of the property. The creditor or the lending party gets the authority to take over the property set as collateral until the whole debt or loan is paid. The creditor can recover at least some part of the unpaid amount by selling the collateral security or property. A tax lien refers to a lien that the government enforces so that individuals can make tax payments. The federal tax lien imposes claims on the assets of the borrower or debtor. A mechanics lien covers claim on the real or individuals own property where the mechanic has offered services. For instance, if you don't make due payments for the services performed on property, then it is the right of the contractor to reserve a claim until you pay the bills. Another form of lien called judgement lien is a legal ruling that gives the right to creditor to have possession of assets of the borrower in case he or she fails to make payments.
- Mortgage - A mortgage is one of the standard types of security interests. It is another form of a lien created against the property. The lending institution, usually a bank, holds an interest in the property's title until the borrower pays off the whole amount of loan. In case, he or she is unable to make full repayment of the mortgage, the lending institution or party can seize the house that is set as a collateral security.
- Restrictive Covenant - A restrictive covenant refers to a contract in which a seller puts restriction for the buyer on how to use the land, and mentions the same in the deed of property of the buyer. For instance, the seller can specify a provision that asks the buyer to not make any amendments to a specific structure of the house or building. Such restrictive covenants don't have any specific criterion, sometimes they can be to the point, and the other times, they can be based on personal choice. They are acceptable till the time they are within legal boundaries.
Application of Encumbrances in Accounting
Encumbrance accounting reserves a particular set of assets for paying the due liabilities. For instance, a firm may set aside some amount of money as reserves for dealing with its accounts payable. The encumbrance creates a belief that the reserves account has more amounts of money than the funds actually required for use. It is important to note that such reserves are not meant to be used for paying any other expenses. Encumbrance accounting takes care of the fact that an organization spends within its budget.
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