diff --git a/examples/mcp_servers/authorization/src/authorization/.env.example b/examples/mcp_servers/authorization/.env.example
similarity index 100%
rename from examples/mcp_servers/authorization/src/authorization/.env.example
rename to examples/mcp_servers/authorization/.env.example
diff --git a/examples/mcp_servers/simple/src/simple/.env.example b/examples/mcp_servers/simple/.env.example
similarity index 100%
rename from examples/mcp_servers/simple/src/simple/.env.example
rename to examples/mcp_servers/simple/.env.example
diff --git a/examples/mcp_servers/tool_chaining/src/tool_chaining/.env.example b/examples/mcp_servers/tool_chaining/.env.example
similarity index 100%
rename from examples/mcp_servers/tool_chaining/src/tool_chaining/.env.example
rename to examples/mcp_servers/tool_chaining/.env.example
diff --git a/libs/arcade-cli/arcade_cli/configure.py b/libs/arcade-cli/arcade_cli/configure.py
index 50ea47c95..7e3e7256c 100644
--- a/libs/arcade-cli/arcade_cli/configure.py
+++ b/libs/arcade-cli/arcade_cli/configure.py
@@ -9,6 +9,7 @@
 from pathlib import Path
 
 import typer
+from arcade_mcp_server.settings import find_env_file
 from dotenv import dotenv_values
 from rich.console import Console
 
@@ -137,10 +138,16 @@ def is_uv_installed() -> bool:
 
 
 def get_tool_secrets() -> dict:
-    """Only useful for stdio servers, because HTTP servers load in envvars at runtime"""
-    # TODO: Allow for a custom .env file to be used
-    env_path = Path.cwd() / ".env"
-    if env_path.exists():
+    """Get tool secrets from .env file for stdio servers.
+
+    Discovers .env file by traversing upward from the current directory
+    through parent directories until a .env file is found.
+
+    Returns:
+        Dictionary of environment variables from the .env file, or empty dict if not found.
+    """
+    env_path = find_env_file()
+    if env_path is not None:
         return dotenv_values(env_path)
     return {}
 
diff --git a/libs/arcade-cli/arcade_cli/deploy.py b/libs/arcade-cli/arcade_cli/deploy.py
index 82a64ff01..ffebb1d20 100644
--- a/libs/arcade-cli/arcade_cli/deploy.py
+++ b/libs/arcade-cli/arcade_cli/deploy.py
@@ -12,6 +12,7 @@
 from typing import cast
 
 import httpx
+from arcade_mcp_server.settings import find_env_file
 from dotenv import load_dotenv
 from pydantic import BaseModel, Field
 from rich.columns import Columns
@@ -747,14 +748,14 @@ def deploy_server_logic(
         )
     console.print(f"✓ Entrypoint file found at {entrypoint_path}", style="green")
 
-    # Step 3: Load .env file from current directory if it exists
-    console.print("\nLoading .env file from current directory if it exists...", style="dim")
-    env_path = current_dir / ".env"
-    if env_path.exists():
+    # Step 3: Load .env file if it exists (searches upward through parent directories)
+    console.print("\nSearching for .env file...", style="dim")
+    env_path = find_env_file()
+    if env_path is not None:
         load_dotenv(env_path, override=False)
         console.print(f"✓ Loaded environment from {env_path}", style="green")
     else:
-        console.print(f"[!] No .env file found at {env_path}", style="yellow")
+        console.print("[!] No .env file found in current or parent directories", style="yellow")
 
     # Step 4: Verify server and extract metadata (or skip if --skip-validate)
     required_secrets_from_validation: set[str] = set()
diff --git a/libs/arcade-cli/arcade_cli/templates/minimal/{{ toolkit_name }}/.env.example b/libs/arcade-cli/arcade_cli/templates/minimal/{{ toolkit_name }}/.env.example
new file mode 100644
index 000000000..c609e3601
--- /dev/null
+++ b/libs/arcade-cli/arcade_cli/templates/minimal/{{ toolkit_name }}/.env.example	
@@ -0,0 +1,13 @@
+# Environment variables for {{ toolkit_name }} MCP server
+#
+# Copy this file to .env and fill in your values:
+#   cp .env.example .env
+#
+# The .env file will be automatically discovered when running your server,
+# even from subdirectories like src/{{ toolkit_name }}/.
+#
+# IMPORTANT: Never commit your .env file to version control!
+
+# Example secret used by the whisper_secret tool
+# Replace with your actual secret value
+MY_SECRET_KEY="Your tools can have secrets injected at runtime!"
diff --git a/libs/arcade-cli/arcade_cli/templates/minimal/{{ toolkit_name }}/src/{{ toolkit_name }}/.env.example b/libs/arcade-cli/arcade_cli/templates/minimal/{{ toolkit_name }}/src/{{ toolkit_name }}/.env.example
deleted file mode 100644
index fe5a74469..000000000
--- a/libs/arcade-cli/arcade_cli/templates/minimal/{{ toolkit_name }}/src/{{ toolkit_name }}/.env.example	
+++ /dev/null
@@ -1 +0,0 @@
-MY_SECRET_KEY="Your tools can have secrets injected at runtime!"
diff --git a/libs/arcade-cli/arcade_cli/utils.py b/libs/arcade-cli/arcade_cli/utils.py
index 256be8e5e..d3536d2ca 100644
--- a/libs/arcade-cli/arcade_cli/utils.py
+++ b/libs/arcade-cli/arcade_cli/utils.py
@@ -27,6 +27,7 @@
 from arcade_core.errors import ToolkitLoadError
 from arcade_core.network.org_transport import build_org_scoped_http_client
 from arcade_core.schema import ToolDefinition
+from arcade_mcp_server.settings import find_env_file
 from arcadepy import (
     NOT_GIVEN,
     APIConnectionError,
@@ -1031,9 +1032,9 @@ def resolve_provider_api_key(provider: Provider, provider_api_key: str | None =
     if api_key:
         return api_key
 
-    # Then check .env file in current working directory
-    env_file_path = Path.cwd() / ".env"
-    if env_file_path.exists():
+    # Then check .env file by traversing upward through parent directories
+    env_file_path = find_env_file()
+    if env_file_path is not None:
         load_dotenv(env_file_path, override=False)
         api_key = os.getenv(env_var_name)
         if api_key:
diff --git a/libs/arcade-mcp-server/arcade_mcp_server/mcp_app.py b/libs/arcade-mcp-server/arcade_mcp_server/mcp_app.py
index 91c594715..242ed82d1 100644
--- a/libs/arcade-mcp-server/arcade_mcp_server/mcp_app.py
+++ b/libs/arcade-mcp-server/arcade_mcp_server/mcp_app.py
@@ -26,7 +26,7 @@
 from arcade_mcp_server.logging_utils import intercept_standard_logging
 from arcade_mcp_server.resource_server.base import ResourceServerValidator
 from arcade_mcp_server.server import MCPServer
-from arcade_mcp_server.settings import MCPSettings, ServerSettings
+from arcade_mcp_server.settings import MCPSettings, ServerSettings, find_env_file
 from arcade_mcp_server.types import Prompt, PromptMessage, Resource
 from arcade_mcp_server.usage import ServerTracker
 from arcade_mcp_server.worker import create_arcade_mcp, serve_with_force_quit
@@ -358,7 +358,7 @@ def _run_with_reload(self, host: str, port: int) -> None:
         This method runs as the parent process that watches for file changes
         and spawns/restarts child processes to run the actual server.
         """
-        env_file_path = Path.cwd() / ".env"
+        env_file_path = find_env_file()
 
         def start_server_process() -> subprocess.Popen:
             """Start a child process running the server."""
@@ -393,9 +393,17 @@ def shutdown_server_process(process: subprocess.Popen, reason: str = "reload") -
         try:
 
             def watch_filter(change: Any, path: str) -> bool:
-                return path.endswith(".py") or (Path(path) == env_file_path)
+                # Watch Python files and the .env file (if one was found)
+                return path.endswith(".py") or (
+                    env_file_path is not None and Path(path) == env_file_path
+                )
+
+            # Watch current directory, plus the .env file if it's outside cwd
+            paths_to_watch: list[str] = ["."]
+            if env_file_path is not None:
+                paths_to_watch.append(str(env_file_path))
 
-            for changes in watch(".", watch_filter=watch_filter):
+            for changes in watch(*paths_to_watch, watch_filter=watch_filter):
                 logger.info(f"Detected changes in {len(changes)} file(s), restarting server...")
                 shutdown_server_process(process, reason="reload")
                 process = start_server_process()
diff --git a/libs/arcade-mcp-server/arcade_mcp_server/settings.py b/libs/arcade-mcp-server/arcade_mcp_server/settings.py
index e8e4b8c1e..1a819b1c4 100644
--- a/libs/arcade-mcp-server/arcade_mcp_server/settings.py
+++ b/libs/arcade-mcp-server/arcade_mcp_server/settings.py
@@ -12,6 +12,59 @@
 from pydantic_settings import BaseSettings
 
 
+def find_env_file(
+    start_dir: Path | None = None,
+    stop_at: Path | None = None,
+    filename: str = ".env",
+) -> Path | None:
+    """Find a .env file by traversing upward through parent directories.
+
+    Starts at the specified directory (or current working directory) and
+    traverses upward through parent directories until a .env file is found
+    or the filesystem root (or stop_at directory) is reached.
+
+    Args:
+        start_dir: Directory to start searching from. Defaults to current working directory.
+        stop_at: Directory to stop traversal at (inclusive). If specified, the search
+                 will not continue past this directory. The stop_at directory itself
+                 is still checked for the .env file.
+        filename: Name of the env file to find. Defaults to ".env".
+
+    Returns:
+        Path to the .env file if found, None otherwise.
+
+    Example:
+        # Find .env starting from current directory
+        env_path = find_env_file()
+
+        # Find .env starting from a specific directory
+        env_path = find_env_file(start_dir=Path("/path/to/project/src"))
+
+        # Find .env but don't search above project root
+        env_path = find_env_file(stop_at=Path("/path/to/project"))
+    """
+    current = start_dir or Path.cwd()
+    current = current.resolve()
+
+    if stop_at is not None:
+        stop_at = stop_at.resolve()
+
+    while True:
+        env_path = current / filename
+        if env_path.is_file():
+            return env_path
+
+        if stop_at is not None and current == stop_at:
+            return None
+
+        parent = current.parent
+        if parent == current:
+            # We've reached the filesystem root
+            return None
+
+        current = parent
+
+
 class NotificationSettings(BaseSettings):
     """Notification-related settings."""
 
@@ -308,16 +361,17 @@ class MCPSettings(BaseSettings):
     def from_env(cls) -> "MCPSettings":
         """Create settings from environment variables.
 
-        Automatically loads .env file from current directory if it exists,
-        then creates settings from the combined environment.
+        Automatically discovers and loads .env file by traversing upward from
+        the current directory through parent directories until a .env file is
+        found or the filesystem root is reached.
 
         The .env file is loaded with override=False, meaning existing
-        environment variables take precedence. Multiple calls are safe
+        environment variables take precedence. Multiple calls are safe.
         """
         from dotenv import load_dotenv
 
-        env_path = Path.cwd() / ".env"
-        if env_path.exists():
+        env_path = find_env_file()
+        if env_path is not None:
             load_dotenv(env_path, override=False)
 
         return cls()
diff --git a/libs/arcade-mcp-server/pyproject.toml b/libs/arcade-mcp-server/pyproject.toml
index 71feef519..ad6bab7d2 100644
--- a/libs/arcade-mcp-server/pyproject.toml
+++ b/libs/arcade-mcp-server/pyproject.toml
@@ -4,7 +4,7 @@ build-backend = "hatchling.build"
 
 [project]
 name = "arcade-mcp-server"
-version = "1.14.0"
+version = "1.15.0"
 description = "Model Context Protocol (MCP) server framework for Arcade.dev"
 readme = "README.md"
 authors = [{ name = "Arcade.dev" }]
diff --git a/libs/tests/arcade_mcp_server/test_env_discovery.py b/libs/tests/arcade_mcp_server/test_env_discovery.py
new file mode 100644
index 000000000..2d35bdc58
--- /dev/null
+++ b/libs/tests/arcade_mcp_server/test_env_discovery.py
@@ -0,0 +1,66 @@
+"""Tests for find_env_file() upward directory traversal."""
+
+from pathlib import Path
+
+import pytest
+from arcade_mcp_server.settings import find_env_file
+
+
+class TestFindEnvFile:
+    """Test the find_env_file() utility function."""
+
+    def test_finds_env_in_current_directory(
+        self, tmp_path: Path, monkeypatch: pytest.MonkeyPatch
+    ) -> None:
+        """Should find .env file in cwd."""
+        env_file = tmp_path / ".env"
+        env_file.write_text("TEST_VAR=value")
+        monkeypatch.chdir(tmp_path)
+
+        assert find_env_file() == env_file
+
+    def test_finds_env_in_parent_directory(
+        self, tmp_path: Path, monkeypatch: pytest.MonkeyPatch
+    ) -> None:
+        """Should traverse upward to find .env in parent."""
+        subdir = tmp_path / "a" / "b" / "c"
+        subdir.mkdir(parents=True)
+        env_file = tmp_path / ".env"
+        env_file.write_text("TEST_VAR=value")
+        monkeypatch.chdir(subdir)
+
+        assert find_env_file() == env_file
+
+    def test_prefers_closest_env_file(
+        self, tmp_path: Path, monkeypatch: pytest.MonkeyPatch
+    ) -> None:
+        """Should find closest .env when multiple exist."""
+        subdir = tmp_path / "subdir"
+        subdir.mkdir()
+        (tmp_path / ".env").write_text("ROOT=1")
+        closer_env = subdir / ".env"
+        closer_env.write_text("CLOSER=1")
+        monkeypatch.chdir(subdir)
+
+        assert find_env_file() == closer_env
+
+    def test_returns_none_when_not_found(
+        self, tmp_path: Path, monkeypatch: pytest.MonkeyPatch
+    ) -> None:
+        """Should return None when no .env exists."""
+        subdir = tmp_path / "subdir"
+        subdir.mkdir()
+        monkeypatch.chdir(subdir)
+
+        assert find_env_file() is None
+
+    def test_stop_at_limits_traversal(
+        self, tmp_path: Path, monkeypatch: pytest.MonkeyPatch
+    ) -> None:
+        """stop_at should prevent traversing past specified directory."""
+        project = tmp_path / "project" / "src"
+        project.mkdir(parents=True)
+        (tmp_path / ".env").write_text("OUTSIDE=1")
+        monkeypatch.chdir(project)
+
+        assert find_env_file(stop_at=tmp_path / "project") is None
diff --git a/libs/tests/cli/deploy/test_deploy.py b/libs/tests/cli/deploy/test_deploy.py
index 0a6768bc6..ff7bf3638 100644
--- a/libs/tests/cli/deploy/test_deploy.py
+++ b/libs/tests/cli/deploy/test_deploy.py
@@ -2,7 +2,6 @@
 import io
 import subprocess
 import tarfile
-import time
 from pathlib import Path
 
 import pytest
diff --git a/libs/tests/cli/test_configure.py b/libs/tests/cli/test_configure.py
new file mode 100644
index 000000000..4d86b9985
--- /dev/null
+++ b/libs/tests/cli/test_configure.py
@@ -0,0 +1,28 @@
+"""Tests for get_tool_secrets() in arcade configure."""
+
+from pathlib import Path
+
+import pytest
+from arcade_cli.configure import get_tool_secrets
+
+
+def test_get_tool_secrets_loads_from_env_file(
+    tmp_path: Path, monkeypatch: pytest.MonkeyPatch
+) -> None:
+    """Should load secrets from .env file."""
+    env_file = tmp_path / ".env"
+    env_file.write_text("SECRET_ONE=value1\nSECRET_TWO=value2")
+    monkeypatch.chdir(tmp_path)
+
+    secrets = get_tool_secrets()
+    assert secrets.get("SECRET_ONE") == "value1"
+    assert secrets.get("SECRET_TWO") == "value2"
+
+
+def test_get_tool_secrets_returns_empty_when_no_env(
+    tmp_path: Path, monkeypatch: pytest.MonkeyPatch
+) -> None:
+    """Should return empty dict when no .env exists."""
+    monkeypatch.chdir(tmp_path)
+
+    assert get_tool_secrets() == {}
diff --git a/libs/tests/conftest.py b/libs/tests/conftest.py
index 71eee2228..61ffe46a0 100644
--- a/libs/tests/conftest.py
+++ b/libs/tests/conftest.py
@@ -9,21 +9,23 @@
 
 
 @pytest.fixture(autouse=True)
-def disable_usage_tracking():
-    """Disable CLI usage tracking for all tests.
+def isolate_environment():
+    """Isolate environment variables for each test.
 
-    This prevents test runs from sending analytics events to PostHog.
-    The fixture is autouse=True so it applies automatically to every test.
+    This fixture captures the entire environment before a test and restores it
+    after. This ensures that environment variables set by load_dotenv() or any
+    other mechanism during tests don't leak into subsequent tests.
+
+    This also disables CLI usage tracking to prevent test runs from sending
+    analytics events to PostHog.
     """
-    original_value = os.environ.get("ARCADE_USAGE_TRACKING")
+    original_env = os.environ.copy()
 
     # Disable tracking
     os.environ["ARCADE_USAGE_TRACKING"] = "0"
 
     yield
 
-    # Restore original value after test
-    if original_value is None:
-        os.environ.pop("ARCADE_USAGE_TRACKING", None)
-    else:
-        os.environ["ARCADE_USAGE_TRACKING"] = original_value
+    # Restore the original environment
+    os.environ.clear()
+    os.environ.update(original_env)
diff --git a/pyproject.toml b/pyproject.toml
index b7cd782eb..8b90897db 100644
--- a/pyproject.toml
+++ b/pyproject.toml
@@ -1,6 +1,6 @@
 [project]
 name = "arcade-mcp"
-version = "1.7.1"
+version = "1.8.0"
 description = "Arcade.dev - Tool Calling platform for Agents"
 readme = "README.md"
 license = { file = "LICENSE" }
@@ -19,7 +19,7 @@ requires-python = ">=3.10"
 
 dependencies = [
     # CLI dependencies
-    "arcade-mcp-server>=1.14.0,<2.0.0",
+    "arcade-mcp-server>=1.15.0,<2.0.0",
     "arcade-core>=4.1.0,<5.0.0",
     "typer==0.10.0",
     "rich>=14.0.0,<15.0.0",
@@ -41,7 +41,7 @@ all = [
     "pytz>=2024.1",
     "python-dateutil>=2.8.2",
     # mcp
-    "arcade-mcp-server>=1.14.0,<2.0.0",
+    "arcade-mcp-server>=1.15.0,<2.0.0",
     # serve
     "arcade-serve>=3.2.0,<4.0.0",
     # tdk