A charge is a claim against a piece of property by a party other than the owner. An encumbrance can affect the property's transferability and restrict its use until the encumbrance is removed. Real estate is subject to the most common types of encumbrance, including mortgages, easements, and property tax liens. Easements are one example of a form of encumbrance that is not monetary. Personal property can also be encumbered, in addition to real property.

What Is an Encumbrance?

In accounting, this term refers to restricted funds within an account that are reserved for a particular liability.

• An encumbrance is a claim being made against a property by someone other than the current titleholder. 

• Certain claims have no impact on the property's value. Typically observed in commercial cases.

• Leases, liens, easements, and mortgages are examples of typical claims.

Understanding Encumbrance

The term encumbrance encompasses a vast array of financial and non-financial claims on a property by stakeholders other than the owner. Some restrictions may prevent property owners from exercising complete, or unfettered, control over their property. In certain instances, the property may be repossessed by a creditor or confiscated by the government.

Certain encumbrances can reduce the marketability of a security, such as an easement or a lien. Although this does not necessarily mean that the title cannot be bought and sold, in some jurisdictions the buyer may be able to cancel the transaction despite having signed a contract and even seek damages.

Other encumbrances, such as zoning laws and environmental regulations, do not affect the marketability of a property, but they do prohibit certain land uses and improvements.

In Hong Kong, for instance, the seller of a property is required by law to disclose any encumbrances against the property to the real estate agent in order to avoid any complications during the sales process. The buyer will receive from the real estate agent a land search document containing a list of any encumbrances.

Types of Encumbrances

As a result of its wide range of applications, real estate encumbrance comes in a variety of forms. Each type is designed to safeguard parties and specify precisely what each claim entails and entitles them to.

Easement

A party's right to use or improve portion sizes of another party's property, or even to prevent the owner from being used or improving the property in specific ways, is referred to as an easement. The first classification is referred to as an affirmative easement. For instance, a utility company may have the right to run a gas line through a person's property, and pedestrians may have the right to use a footpath traversing the property.

It is important for the buyer to be aware of any encumbrances on a property, as these will frequently transfer to them along with the property's ownership.

An easement in gross benefits an individual rather than a property owner, so Jennifer may have the right to use her neighbor's well, but this right would not transfer to the buyer of her property. For instance, a negative easement prohibits the title-holder from constructing a structure that would block a neighbor's light.

Encroachment

Encroachment occurs when a non-property owner intrudes or interferes with the property, such as by constructing a fence over the lot line (a trespass) or planting a tree whose branches extend onto an adjacent property (a nuisance). A trespass creates a burden on both properties until the issue is resolved: The land containing the encroachment has its free use restricted, whereas the owner of the encroaching improvement does not own the land on which it is constructed.

Lease

A lease is an agreement to rent a property for a specified price and term. It is a form of encumbrance because the lessor does not relinquish ownership of the property, but the lease significantly restricts the lessee's use of the property.

Lien

A lien is a type of security interest that affects the title to a piece of property. It gives the creditor the right to seize the property as security for an unpaid obligation, typically a debt. The creditor may then sell the property to recoup a portion of the loan.

A tax lien is a lien imposed by the government to compel payment of taxes; in the United States, a federal tax lien takes precedence over all other claims on a debtor's assets. A mechanic's lien is a claim on real or personal property made by a service provider. An example would be if a contractor made alterations to your property without receiving payment. Judgment liens are secured by the defendant's assets in a lawsuit.

Mortgage

A mortgage is among the most prevalent forms of security interests. Essentially, it is a lien on a piece of real estate. Until the mortgage is repaid, the lender, typically a bank, retains an interest in the title to the property. If the borrower cannot repay the mortgage, the lender may foreclose on the property, seizing it as collateral and evicting the occupants.

Restrictive Covenant

A restrictive covenant is an agreement that a seller includes in a buyer's deed to limit the buyer's use of the property. There could be a clause requiring the buyer to maintain a building's original facade, for instance. As long as restrictive covenants do not violate the law, they can be as specific and arbitrary as the parties agree.

Special Consideration for the Use in Accounting

Accounting for encumbrances reserves specific assets to pay anticipated liabilities. For instance, a business may set aside cash to settle its accounts payable. The presence of an encumbrance can create the illusion that a bank account contains more funds than are actually available for use. The set-aside funds cannot be used for other transactions or expenditures. Therefore, encumbrance accounting ensures that a business does not exceed its budget.