Had this problem today while working through the Mobile Development with C# book written by Greg Shackles.
Chapter 3 makes reference to creating a ‘MonoTouch Library Project’ which you then go on to add as a project reference in Chapter 4. When I tried to add the project reference I received the ‘Incompatible Target Framework’ message although I could reference the dll OK. Turned out that when I’d created the ‘MonoTouch Library Project’ in Xamarin Studio, I’d created a ‘C# Library’ and not an ‘iOS Library Project’. The terminology / labels have obviously changed since the book was published and ‘MonoTouch Library Project’ is now ‘iOS Library Project’ so watch out for this gotcha!