I am not able to test my apps on my iPhone 3GS that runs iOS 4 with Xcode 3.1.4.
I can't install Xcode 3.2 because it appears it needs Mac OS X 10.6 and above.
What are my options here then, because I don't want to pay for OS X 10.6. Is it possible to just have an upgrade?
If this is totally binding, is it possible to downgrade my phone from iOS 4 to iOS 3.1?
I haven't tried this but I think this will work. You can try creating an ad-hoc distribution profile for your iPhone with the app id and install your app on the iPhone through iTunes. This way you'll be able to test your app but you can't debug it for sure.
Ad-hoc distribution is the only way can get it work and I dont think that you can install iOS 3.1 in iPhone 3GS in your case.
I would suggest you just lay down the money for 10.6.
Apple are moving forward and not looking back. You can't stay on 10.5 forever, especially if you're a developer. You need to be working with the latest tools and SDKs in order to benefit from bug fixes and performance improvements.
Downgrading isn't officially supported, so that's something you'll have to find out how to do yourself, and may lead to problems/difficulties and may even make your iPhone unusable. (just stating the risks).