Mr Sánchez tabled the motion of no confidence after Mr Rajoy's centre-right People's Party (PP) was implicated in a huge corruption scandal.
It's a move that will nearly certainly force him out of office.
With most Spanish parties and Sanchez himself being pro-European, investors however see less broader political risk there than in Italy.
An absolute majority of 180 lawmakers voted for the motion to loud applause and shouts of "Yes we can", converting Rajoy into the first prime minister to be ousted by such a vote since Spain transitioned to democracy in 1977.
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The 63-year-old is accused of failing to take responsibility for his party's involvement, which came to light last week after a former treasurer Luis Bárcenas was jailed for 33 years for receiving bribes, money laundering and tax crimes.
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It will be the final stage of a three-part probe into the system, created to ensure members get bang for their buck. The excess fees and insurance premiums paid by members on those accounts amount to $2.6 billion every year.
Catalonia's two biggest pro-independence parties - Puigdemont's PDeCat and the Catalan Republican Left - lent their support to Sánchez's successful attempt to unseat Rajoy and will be keen to get something in return.
In his brief address - perhaps his last Spain's leader - he also thanked those in his party and the Spanish people.
Following the vote, Rajoy went over to Sanchez in the chamber and shook the incoming leader's hand.
The Madrid stock exchange was up almost 1.6 percent after Sanchez won the vote, earning a standing ovation from his party's lawmakers.
He has also promised to start talks with the Catalans over their bid for independence, but said he will not give them another referendum.
The parliamentary debate resumed at 9 a.m. (0700 GMT) and the vote of confidence is expected at around 12 midday (1000 GMT).