#2 - closest to you and doesn't get as much downstairs noise wins. i would try to arrange her crib so it's not sharing a wall with your room though, just to mitigate any noise when you go to bed.
closet size wouldn't play into my decision at all. whoever has the bigger closet can hold the hand me downs until they are in use.
If your DD1 is happy in her room I wouldn't change her. While the closet would be nice, I think having to set up 2 rooms would be so hard, especially while pregnant. Plus the location of bedroom 2 will be nice with proximity to your room and not have the noise like you said bedroom 1 has.
Sorry, I just reread the OP. I thought DD1had to move rooms to have the bigger closet. dD1 stays where she is. The largest closet for hand downs is very foreign logic to me and I wouldn't even entertain that thought. Make the decision on the other factors. Baby closest to you. Older girl, bigger closet. ONE LESS PERSON TO MOVE ROOMS. This seems a no brainer to me.
Baby goes closest to you. The bigger girl needs the bigger closet. Also, you won't have to walk past her bedroom to get the the baby, so less noise to wake her middle of the night.
I hope I'm understanding the layout correctly, I would put DD2 in bedroom #2. I would not move DD1. I think forcing an almost 5yo to give up her room for a new baby would breed resentment.