What Is an Encumbrance?
An encumbrance is a third-party claim that can limit a property owner’s rights, impacting transferability and usage. Particularly common in real estate, encumbrances include both financial types like mortgages and liens, and non-financial forms such as easements, which do not involve monetary claims. Understanding these can help you identify potential barriers to property transactions.
As an accounting term, “encumbrance” refers to restricted funds inside an account that are reserved for a specific liability.
Key Takeaways
- An encumbrance is a third-party claim or right on a property that can affect its use or sale.
- Common types of encumbrances include mortgages, liens, easements, and restrictive covenants.
- Encumbrances can be financial, like liens, or non-financial, like easements and zoning laws.
- Real estate buyers should investigate any encumbrances before purchasing, as they transfer with property ownership.
- Encumbrance accounting involves setting aside funds for specific liabilities to prevent overspending.
How Encumbrances Affect Property Owners
An encumbrance includes many financial and non-financial claims on a property by non-title holders. Property owners may be encumbered 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.
How Encumbrances Influence Property Marketability
Some encumbrances can make securities harder to sell. For example, if an investor uses the securities in a brokerage account as collateral for a loan from the brokerage, they may not be able to sell them. The brokerage would be able to take them in case of default by the investor. If sold, the brokerage can take enough proceeds to cover the loan.
An easement or a lien can make a title unmarketable. It might not stop a sale but it can let a buyer back out, even after signing a contract. Buyers may even seek damages in some jurisdictions.
How Encumbrances Restrict Property Use
Zoning laws and environmental rules don’t hurt marketability but limit how land can be used or improved.
That’s why, for example, in Hong Kong, the seller of a property is legally required to inform the real estate agent and purchaser of any encumbrances against the property to avoid problems 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.
Common Types of Encumbrances Explained
Real estate can have many types of encumbrances due to its varied uses. Each type of encumbrance is meant to protect parties and specify exactly what each claim entails.
Easement
An easement refers to a party’s right to use or improve portions of another party’s property, or to prevent the property owner from using or improving the property in certain ways.
An affirmative easement allows the party that possesses the easement to use a property as defined by the easement. 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. Holders of the easement must abide by its terms or face potential legal action.
A negative easement allows the party that possesses the easement to stop certain actions as defined by the easement. For example, a neighbor may have the right, based on agreement with the property owner next door, to prevent that owner from mowing their lawn on certain days of the week.
An easement in gross benefits the easement owner as an individual rather than as an owner of a property. Therefore, the easement can’t be passed on to anyone who might buy the easement owner’s property. It is nullified once the easement owner moves.
For example, Jennifer owns an easement, that she negotiated with her neighbor, that gives her the right to use her neighbor’s well. But that right would not pass on to someone who bought Jennifer’s property.
Encroachment
Encroachment occurs when someone interferes with property, like building over a lot line or planting trees that cross boundaries.
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 whereby someone rents a property for an agreed-upon rate and period of time. It is a form of encumbrance by which the lessor (landlord) does not give up title to the property, but their 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 claimant the right to seize the 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 an encumbrance 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 lien is a claim on personal or real property made by a claimant who has performed services on the property. For example, if a contractor made adjustments to your property that were never paid for, the contractor might establish a lien.
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, seizing the house as collateral and evicting the inhabitants.
Restrictive Covenant
A restrictive covenant is a seller’s rule in a property deed limiting the buyer’s use of the property. For example, there might be a provision that requires the buyer to leave a building’s original facade intact. As long as they do not break the law, restrictive covenants can be as specific and arbitrary as the parties involved are willing to agree to.
Important Considerations for Understanding Encumbrances
Encumbrance as Used in Accounting
Encumbrance accounting refers to money set aside to pay for anticipated liabilities. For example, a company may reserve a sum of cash to settle up obligations in its accounts payable. And salaries that must be paid to employees are an encumbrance.
An encumbrance can make an account seem to have more free funds than it really does.
Set-aside money can’t be used for other expenses or transactions. Encumbrance accounting, therefore, ensures that a business does not overspend its budget.
What If I Buy Real Estate With an Encumbrance?
That depends on the encumbrance. An encumbrance on your newly purchased property may be simply a mortgage. Or it may be a financial lien placed by someone owed money for work they did for the previous owner, that wasn’t paid. It could be a property tax lien placed by the county. Or it might be a zoning regulation that prohibits you from building a structure you’d hoped to have. Be sure to research all possible encumbrances before you purchase a home so you understand how you might be obligated financially or otherwise.
What Does It Mean If a Property Is Encumbered?
It means that some party has placed a claim on the property that affects what the property owner may do with it.
How Do I Find Out About Encumbrances on a Property?
You can request this specific information from your real estate agent or the seller. In addition, when you perform a title search, you should find out about any outstanding claims or liens.
The Bottom Line
An encumbrance represents a third-party claim or right that can influence a property’s use or sale. Common examples include mortgages, easements, liens, and zoning laws. Each type of encumbrance might impact property owners differently, either financially or in terms of property restrictions. Before purchasing a property, thoroughly investigate any existing encumbrances to understand potential obligations or limitations they may impose. Knowing this information ensures you can make an informed decision about proceeding with or withdrawing from a transaction.