I have three girls, and hand just about everything down. Unless there are rips or stains, which is very rare. When we found out the second one was also a girl, we got more generous buying the older one more "high end" clothing like Hanna, because we knew it would be used for at least two kids. The cheaper things, like Target, Old Navy, Carters, etc, looked a little sad when they got to DD #3, so we did end up buying her a few new things here and there. DD #2 gets a couple of new pieces each season, but not much. Usually when it's something she really really likes (like the avocado dress we just bought at Target).
We don't pass down underwear, but socks are usually okay. I store all the clothing by size and season (warm/cool) in big see-through plastic bins in our laundry room. A few times a year, I do a big swap out. The kids love checking out all their "new" clothes. When DD #3 outgrows clothing, I either pass it on to a few friends that I know will use it, sell it at Totswap, or donate.