What is an Encumbrance?
An encumbrance is a legal restriction on an asset, such as a piece of property in real estate, that may affect the transfer of the asset or restrict usage.
Encumbrances are commonly found in real estate. Some encumbrances may affect your ability to sell a property, while other types do not affect the value of the land at all. Most encumbrances are claims against a property by a third party. These claims are liabilities for the property owner. In accounting, encumbrances are funds that are reserved in a budget for a specific purpose. These restrictions are common in government accounting to ensure that the money is there when it is time to pay an obligation, such as employee payroll and benefits.
Let’s say a homeowner hires a contractor to renovate and upgrade the kitchen of their house. If the homeowner doesn’t pay the contractor, the contractor may place an encumbrance on the house by filing a mechanic’s lien. This encumbrance is a “hold” against the property. If the homeowner does not settle the mechanic’s lien, a judge may order foreclosure on the house. Money from the sale of the home would satisfy the encumbrance and pay the contractor.
An encumbrance is like an anchor on a boat…
Encumbrances can be a burden on a property. An encumbrance may restrict homeowners from using the property in some way, affect a house’s marketability, or even allow a creditor to seize the property for an unpaid debt. Encumbrances – like an anchor – can weigh a house down until the homeowner settles the claims.
There are two definitions of encumbrance.
In real estate, an encumbrance is a claim against your property by a third party (someone that is not the owner). Some encumbrances can impact a seller from transferring ownership during the sale.
In accounting, an encumbrance is a restriction on funds. The money is set aside in the budget and reserved for a specific obligation, such as a contract.
A property can have different types of encumbrances attached to it. Homebuyers need to pay special attention because lenders may refuse to finance a property that has encumbrances.
There are four primary types of real estate encumbrances:
Liens are financial encumbrances. A lien is a monetary claim against a property because of an unmet obligation, such as unpaid debt. Liens affect the transfer of title when you sell the house because they give a creditor the right to sell the property to ensure payment.
For example, a tax lien is from the government because the property owner has failed to pay its property taxes. Another common lien is a mechanic’s lien, where a contractor or subcontractor hasn’t been paid for his or her services. Similarly, a lender may file a mortgage lien if the borrower has missed mortgage loan payments.
In each case, the property serves as collateral for outstanding debt. As a result, the lienholder has a security interest in your house and has the legal right to seek payment. Eventually, a judge may order foreclosure on the encumbered property to satisfy the liens and pay the creditors.
A deed restriction is a restrictive covenant or agreement that the seller writes into the deed of a property. It restricts the use of the property or prevents the homeowner from making certain changes to the home.
For example, in historic districts, a home may have a deed restriction where the owner cannot change the historical elements of the house, such as the original facade of a building. Other deed restrictions may say that you can only park your cars in a particular area on the land.
Deed restrictions are meant to protect property values or maintain a standard of use from owner to owner.
An easement is a legal right for a third party to use a property in some way. For example, a utility company may have a utility easement so that it can place and maintain power lines on your land.
Another example is if your neighbor’s home is land-locked (the property has no direct access to it, such as from a public road). Your neighbor may have an easement to cross your land to get to theirs.
Another type of encumbrance is an encroachment. That is when a third-party has a structure that crosses the property line onto your land.
For example, if your neighbor’s shed is over the lot line, it is an encumbrance on both parties until they fix the issue. It is an encumbrance for you because the structure prevents your free use of your land. It also encumbers your neighbor because he doesn’t have the title to the land that he built his shed on.
A lien is a common type of encumbrance, but not all encumbrances are liens. Of all the encumbrance types, a lien refers explicitly to a monetary claim against property and can decrease the value of the property.
Liens can affect the transfer of property because most lenders won’t finance a home loan that doesn’t have a clear title (a title without liens). The creditors, or lienholders, have the right to take legal action to force the homeowner to pay the outstanding debt. That is why lenders require a title report as part of the home buying process. This report reveals all liens, easements, encroachments, and anything else in the country records against the property.
Similarly, homebuyers also get a title insurance policy to protect them from issues that the title report may have missed. So, if six months after you purchase a home, you find out that there are years of unpaid taxes on the property, your title insurance will kick in and cover the legal fees to resolve the issue.
Other encumbrances can be non-financial. They may just be an inconvenience to the new owner, although it may affect a property’s marketability. For instance, a lender may be willing to finance a house with an easement that lets your neighbor cross the property. But, the potential homebuyer may not necessarily want this and choose to back out of the sale.
To get an encumbrance for unpaid debt, you’ll need to file a lien in the county where the property is located in. The procedures, laws, and rules around filing for liens vary in every state and locality –- Talk to the country clerk to get details.
To get a deed restriction on your property, you’ll likely need to fill out an application and record it with the county clerk. Some localities have templates or agreements that you can fill in with the relevant information.
Similar to a deed restriction, to get an easement, you’ll need to record the agreement with the county clerk. Both the property owner that is granting the easement and the person using the easement must sign the document. Both the deed restriction and easement forms need a notary’s signature as well.
Finally, if your neighbor is encroaching on your property, you’ll need to resolve it with them. One option is to grant an easement (usually with some type of financial compensation to you). You could also take legal action to remove the encroaching property in civil court.
Another type of encumbrance relates to accounting –- In finance, an encumbrance is money that is set aside to pay a specific obligation or liability. It helps prevent overspending by making sure that the funds are reserved and ready when they are needed.
An encumbrance account holds funds for a purpose, and the bill is not due in the future. For example, if a business places an order, but the company has not received the goods yet, the funds are encumbrances – They are available for the purchase when the order and bill arrive.
On the other hand, accounts payable is money that is owed. The company has already received the goods but has not paid the bill yet.
In government accounting, the budget is a legal requirement. Appropriations, encumbrances, and expenditures must follow a strict process in governmental accounting. On the other hand, in the private sector, the budget functions more as a management tool to assess operations, so these three terms may not always apply.
Appropriation is an amount set aside from the budget to pay for specific items. In governmental accounting, you estimate your appropriations for general categories at the beginning of the year.
When contracts and obligations come up, encumbrances reserve a specific amount from the appropriations. Encumbrances usually come up after you initiate a purchase order. The encumbrances amount stays on an accounting balance sheet but is reported as assigned, committed, or restricted.
Expenditures are bills, invoices, or charges. Many expenditures need to be encumbered before they are paid.
For example, let’s say a business has a budget of $1M. It appropriates $300,000 for equipment. The owner signs a purchase order for $250,000 in new equipment, deliverable in one month. $250,000 is now encumbered to pay this contract in one month. When the bill arrives, it is an expenditure that can now be paid using the encumbered funds.
What is Finance?
What is a Federal Housing Administration (FHA) loan?
What is a Reverse Mortgage?
What are Accounts Receivable?
What is an Income Statement?
What is a Balance Sheet?
What is market capitalization?
Market capitalization (aka “market cap”) is one key way to measure the size of a company by simply multiplying its total number of shares by its stock price.
What is a Stock Split
A stock split cuts the price of the stock to make it more affordable by proportionally increasing the number of shares available — All without changing the overall value of the company (and a “reverse stock split” is the opposite, increasing the price by reducing the number of shares).
What is the Compound Interest Formula?
The compound interest formula, A=P(1+r/n)^nt, lets you quickly calculate the value of your total funds, aka the principal plus interest, when the interest is compounded over that time period.
What is Purchasing Power Parity (PPP)?
Purchasing power parity (PPP) is an economic metric that compares the standard of living between two countries by weighing the amount of each currency needed to buy similar goods.
What is a Beneficiary?
A beneficiary is a person who benefits, profits, or gains from something — in finance, typically an insurance policy, will, or trust fund established by a grantor.