Encumbrance refers to the restriction placed on the usage of certain funds. This definition of the term is used in accounting. These funds are restricted for a specific liability. However, when used for real estate, the term refers to a claim on a property that is not placed by the owner but by a secondary party.
The most common kinds of encumbrance applied in the real estate sector include mortgages, easements, and property tax liens. Encumbrance can be non-financial when it is applied to personal property.
Encumbrance affects the transferability of a property and limits its free usage until the burden is lifted.
Mortgages are obvious examples of encumbrance. If a homeowner does not keep up with the mortgage's repayment, the lender can foreclose the property. This means that the lender can take away the ownership rights of the property from the borrower.
Other examples include lien, or a claim on a property along with zoning laws and environmental restrictions.
Encumbrance has various forms when it comes to real estate depending on its usage. Each form is intended to protect all parties and clarify the roles involved and what the parties are entitled to.
Such type of encroachment is an encumbrance for both the one partaking in the encroachment as well as the victim of the encroachment. The victim’s free use of his own property is encumbered whereas the encroaching party does not hold the title to the land on which this extension has been built on.
An easement can be more beneficial to the secondary party rather than the owner. The easement allowing modification powers to the secondary party is known as affirmative easement while the preventive easement is called negative easement.
This right allows the lender full access to the collateral, which he can then sell to gain back some of the money he had lent. Similarly, tax liens are also imposed by the government to encourage tax payments while judgement liens are secured against the assets of the defendant.
In case repayment is not made, the lender can foreclose by evicting the inhabitants and taking full control of the house.
Even after the building is sold, the previous seller can introduce certain restrictions like holding onto the house's structural integrity and shape, etc.
An encumbrance certificate is a certificate of assurance stating that the underlying property is free from any legal or monetary liability. This includes liabilities like a mortgage or an uncleared loan.
Such a certificate is essential for the buyer of a house to ensure that his legal rights are secured over the title of the house. An EC also ensures that the new homebuyer can obtain loans from most banks and financial institutions.
An encumbered property can be a tricky one to purchase without full knowledge of the subject. Homebuyers may sometimes refrain from purchasing an encumbered property altogether out of fear of losing out on legal rights.
However, it is important to note that not all types of encumbered property could put the buyer at a loss. Thus, it is a great practice to be fully aware of the contents of an encumbrance agreement.
On the contrary, certain encumbrance agreements may hold additional responsibilities that can be passed onto the new buyer. Thus, if they are not settled before closing, it can be a wrongly imposed burden on the new house owner. These may include financial encumbrances apart from the mortgages. It is always good to consult either a real estate professional or a legal advisor in such instances.
How is encumbrance used in accounting?
In accounting, encumbrance sets aside certain funds to pay for forthcoming liabilities. With an encumbrance, firms and institutions may sometimes have an illusion of higher number of funds available with the company.
These funds generally can not be used for any purpose other than for what they are intended for. This type of budgeting ensures that businesses and institutions do not overshoot their limit by using them for expenditures or other transactions.