Can I use the character ñ in a sub-domain?

We are launching our website in Spanish and are probably going to call it

espanol.mydomain.com

Since the real spelling is español, ideally we would allow people to type español.mydomain.com.

Is that something that is possible today? Can we use this character in domains and sub-domains?

Yes, you can use "español" as a subdomain as well as a domain. When a user types "español.mydomain.com" into their browser, it will be translated into Punycode and the request will be made to that URL which would look like "xn--espaol-zwa.mydomain.com".

As a test, I set up that subdomain on one of my domains and in configuring it, I used "xn--espaol-zwa" instead of "español".

What you are looking for is called an Internationalized Domain Name (IDN). Yes it is possible on most ccTLDs as well as some of the more traditional TLDs.

Wikipedia Article
.com info from verisign

Sure you can use it. The punycode version is xn--espaol-zwa.mydomain.com. It doesn't matter if the TLD (.com) allows IDN names, because is a third level domain and in .com is up to you what you put in the third level. Your main concern is with the browser support with idn, but now is natively supported in the last versions of firefox, explorer, and chrome, by the way.