If elves can't build down, and can't build across... perhaps they can build up? Make their homes in the trees, make their homes look LIKE trees. They'll need something that gives them cheap/free buildmats, or perhaps someone can work some DFhacky magic to instagrow structures from reactions complete with stairs... but that is probably impossible.
That is possible. A building growing upwards is yet another reverted drilling rig. Gnomes drill holes everyday (technically they build something that looks like a hole).
First you build a "root"(drilling rig) with a block and a seed, and run a reaction "pray for a living wooden wall"(extend the drill) then a wall is dfhacked above the "root". The more you pray, the higher the wall will grow.
You've got the right idea, but hacking tiles is hard. If you've looked at the drilling rig closely, you may notice that the drill tends to take on the color of the default layer's stone, but is not in fact made out of anything, and deconstructing a section of the drill turns it into dirt.
Making cheap buildmats is possible, if you can think of a way to explain it. Would elves grow seeds into wooden blocks and then build houses with them? Seems a bit off...
I think the best thing for now would be to give elves a different focus entirely: they simply don't build at all. Similar to the ultra-hard self challenge of 'no digging, no building' forts, but with many abilities to make such gameplay viable. As long as their workshops are small, the trees shouldn't get in the way - now that trees have roots, they are automatically prevented from growing too close together. As for fighting enemies, I'm thinking magic. Animals won't bother them anyway, sieges will probably take a while since the only way to increase your fort's value is through production, which is slow, and that gives you plenty of time to produce the means of driving off sieges through nontraditional methods: magically reducing their morale through fear, summoning torrential downpours that push them around, calling the beasts of the forests against them, growing treants...
On another note, I'm just working out the kinks of a script that combines soul manipulation with body construction, and it is very, very flexible. Possibly of use for many existing races, definitely much better than the old 'butcher creatures to get their souls' method.
Transferring souls between creatures, storing multiple souls in a single body, constructing creatures from raw materials in reactions, constructing astral projection or demonic bodies
from souls based on the soul's race and caste (that may or may not retain the original soul's loyalty and may or may not evaporate when the soul is removed), creating soulless creatures that can receive a soul later, and destroying souls to make items are all possible. Splitting or combining (consuming) souls are the next step. I think I'll forget about storing souls in items for now, the game doesn't really support it and most of the solutions I have tried are hacky at best or crashy at worst. (But constructing a 'soul gem' creature from a gem that dies and reverts back to an item when the soul is removed is possible. As are various other possibilities.)