The leader of the conservative Popular Party (PP) which won the last general election held in June 2016, lost Wednesday's vote of confidence after received 170 of the 176 votes needed for an absolute majority in the 350-member body.
He was backed only by his own party, the centrist Ciudadanos and a lone MP from the Canary Islands.
Amid economic austerity imposed by its lenders and the European Commission, Spain has been in a political deadlock since December 2015 general election when political parties failed to form a coalition government. Spaniards voted for the second time within a six months span at the end of June 2016 when Mariano Rajoy won but not with a necessary majority. Also, the Popular Party has been hit with a series of major scandals, leading to arrests of several of its members, and it was the first ever political party to be prosecuted under corruption laws.
The Socialist Party, who came second in the polls, have refused to back Mariano Rajoy as Prime Minister, with leader Pedro Sanchez telling the assembly that the acting prime minister had “no credibility”. In the past, they had expressed some openness to form a coalition government with the PP should Rajoy step down, which however Rajoy refused.
Another confidence vote will be held on Friday, in which the Popular Party will only need more votes in favor than against. Delegates can abstain and a simple majority would suffice to allow Rajoy to form a PP-led minority government. He would only need 11 abstentions to win, but a loss is also likely if the Socialists do not cede.
If there is no breakthrough, voters will be asked to return to the polls on December 25, the date determined by timings laid out in Spanish election law. Socialists and other parties have already proposed shortening the campaign so a repeat election could be held on December 18.