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How does Irving use magic and fantasy in his American Folklore stories, and what effect do they have on character and plot development? I'm trying to focus on "The Legend of Sleepy Hollow" and "Rip Van Winkle".

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The thing to focus on in answering this question would be the way in which Irving deliberately creates a setting for these two stories that places them in the heart of fantasy and which stresses the power of the imagination. These are key aspects to the stories that help us understand the actions (plot developmenty) that follow and the protagonists' reactions (character development) to what occur to them. Let us remember how Irving describes the setting in "The Legend of Sleepy Hollow":

A drowsy, dreamy influence seems to hang over the land, and to pervade the very atmosphere . Some say that the place was bewitched by a high German doctor, during the early days of the settlement; others, that an old Indian chief, the prophet or wizard of his tribe, held his pow-wows there before the country was discovered by Master Hendrick Hudson. Certain it is, the place still continues under the sway of some witching power, that holds a spell over the minds of the good people, causing them to walk in a...

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Irving was consiously attempting to produce "American" fables.  Fables traditionally rely on "magic" if you will, to move the story along. It was a somewhat unusual approach, given that Irving was smack-dab in the middle of the Age of Reason.

As I said, though, his was a conscious attempt to produce these, unlike the traditional fables of Europe, that developed over centuries (at least) from the oral tradition to, finally, the written. Using "magic" allows writers of such stories to skip over certain aspects of the story such as "what caused Rip to sleep so long," and use of the supernatural as a causative element.

Modern science fiction can be used in comparison; SF (real SF) explains everything.  You don't go back in time by snapping your fingers and spitting over your left shoulder.  Modern fantasy is more like traditional folklore (such as Irving was creating) in that while such things are described as having a cause in some (typically) universal energy source (think: Star Wars' "force"--Star Wars is science fantasy, not SF) that "adepts" can tap into.

In Irvings case of very early "fantasy" if you will, he was tapping into supernatural forces such as the "trolls" on Rip's mountain and the headless ghost.