Yes you CAN build .Net 3.5 apps from VS 2005
According to Charles Young you simply need to install .Net 3.5 and change any relevant assembly references to .Net 3.5 versions. Of course, you can use the new language features such as the LINQ query syntax. But you could use the extension methods as regular static methods, for example.
However, in Scott Gutherie’s blog entry on the release of VS2008/.NET 3.5 this comment specifies a problem with upgrading the Ajax code. (Or maybe he did not upgrade the Ajax code.) From Scott’s reply they are not expecting any issues with the upgrade. There are tons of comments to this blog entry I may be work your wile to peruse the list to see if there are any other potential gotchas.
Daniel Moth affirms that the “Red Bits” of 3.5 are just the SP1 for .NET 2.0 and .NET 3.0.
A word of warning from Rick Straw: From an administrative standpoint the CLR is still at v2.0.