I am trying to host a WF4 (RC) Service dynamically. I have a test solution with two projects. The first is a declarative workflow service library with one root Flowchart act
You're deserializing the xaml file directly, but it is referencing a type (CodeActivity1) that is compiled as a CLR type into the DeclarativeServiceLibrary1 assembly. The most obvious answer is that the DeclarativeServiceLibrary1 assembly is not available to the console app at runtime. Make sure that this assembly is copied into the folder where you are running the console app (\bin\debug) and see if that makes a difference.
The bottom line is that even though you are reading the xaml file directly, it still needs access to any types that it references.